Markets Weekly podcast – 7 October 2024

Julien Lafargue (JL): Welcome to a new edition of Barclays Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist, here at Barclays Private Bank, and I will be your host today.

As usual, we will first go through last week’s events before moving on to our guest segment. And, today, I’m very pleased to be joined by Nikola Vasiljevic, Head of Quantitative Strategy here at Barclays. 

And we’re going to discuss expectations going into the US presidential election. We’re now less than a month away from this key catalyst. So, we will see with Nikola what’s priced in and what to expect. But, first, let’s look at the week that was.

The biggest focus for markets was obviously on US labour market data. We got a few data releases throughout the week, starting with the ADP figures, which show that the private sector added 143,000 jobs in September. We also got initial jobless claims, which remain around the 220,000 mark. 

Meanwhile, the JOLTS data showed a solid increase in job openings, although this was slightly overshadowed by a further decline in the quit rate, meaning that people may not be finding it easy to switch jobs at the current time. 

But the most important release of the week came on Friday, with the nonfarm payrolls, and those were, very, very good. They came in at 254,000, easily surpassing expectations. The consensus was looking for about 140,000 to 150,000. In addition, the US unemployment rate ticked lower to 4.1%, so a very solid report.

Now, digging into the numbers a bit, you would see that education and health services contributed the most to this significant increase in job creation in the US. And, in fact, these two sectors have accounted for almost half of all the jobs that have been created in the last six months.

Now, the cynic in me would say that these two sectors tend to be driven, or at least influenced, by the government and, you know, we are in an election year, so maybe there is something there. But, that aside, clearly a very, very strong US job market.

Now, we also had other macroeconomic indicators coming from the US in the form of the US manufacturing and services ISM. And both were relatively mixed. Looking at manufacturing first, activity remained in contraction territory, ie below the 50 mark. It was stable month on month. 

But what was encouraging is the fact that services, which obviously represent a larger share of the US economy, show a significant improvement. It jumped from 51.5 to 54.9, so clearly a strong and continued expansion within services. This is clearly a development that favours the ‘soft’ landing scenario, but let’s bear in mind that it doesn’t absolutely guarantee stronger growth ahead.

Now, the final piece of the puzzle came in the form of inflation data, not in the US, we’re going to get that this week, but around the world we actually got continued signs of disinflation. Particularly in the eurozone, headline inflation dropped to 1.8% year-over-year in September, so we’re already below the central bank target. 

In Switzerland, where Nikola is, that number was a mere 0.8%, and even on the other side of the world in South Korea, consumer prices also expanded by less than expected, 1.6% versus 2% expected. So, the disinflationary impulse is really a global one.

We have to monitor that in the coming weeks and months, given the recent flare-up in oil prices, in particular being driven by the tensions in the Middle East. The good news is the other key factor that could have led to higher inflation, in particular, in the US, namely the strike in US ports, was resolved after only three days, so the impact should be rather minimal.

And that’s good news I’m sure for Kamala Harris, in particular. going into the US election a month from now. So, now it might be a good time to bring Nikola into this conversation, since we’re talking about the US election.

What we’re going to discuss with Nikola is not so much what we expect in terms of the election outcome, that remains a coin toss, but we’re going to discuss what markets are expecting and what they are pricing in at the moment.

So, Nikola, thanks very much for joining us. You just wrote a piece in our Market Perspectives for the month of October looking at what markets, and in particular option markets, are pricing in in the run up to the upcoming US presidential election. 

So, to dive a bit deeper into the implication of this election on financial markets, I’d like to get a sense from you as to whether you think it makes sense to look at the US election and maybe try to position ourselves ahead of it, maybe using options. Some people think that that could be a superior way, not only to express a view but also it’s a market that gives a very specific set of insight into the elections. So, can you share maybe some thoughts around that?

Nikola Vasiljevic (NV): Yes, absolutely. So, morning, Julien. Thank you for having me on the podcast today, and hello to all our listeners.

So, maybe let me start by saying that, as we know well, developed and liquid financial markets are quite efficient when it comes to incorporating any valuable piece of information to us as prices, and this holds across all major asset classes from bonds and stocks to commodities and currencies.

So, option contracts that we will be discussing today are not an exception in this regard, since they are financial derivatives that give the buyer of the contract the right but not the obligation, as we know, to buy or sell an underlying asset, like the ones I’ve just mentioned, at a pre-defined price and before or on a specific expiration date.

So, typically, options are used for hedging, speculation or leveraging market positions and they allow traders to express their views regarding, a) specific price ranges and b) specific time horizons.

As such, they allow us, so to say, to glean insights about future price movements, volatility and the overall sentiment of an underlying asset, based on the trading activity and pricing in option markets.

Now, to your questions, if option contracts provide superior information to other market indicators and how they are positioned overall, I would say that option markets usually complement what is available in underlying spot markets, which are the markets where securities are traded for immediate delivery. But sometimes they can take the lead, and this is why it makes sense to have a closer look and, in particular, around some major events like elections.

It’s perhaps worth mentioning that, generally, the key indicator that is monitored by traders is actually implied volatility, which is derived from option prices and reflects market expectations of future volatility over a specific time period. And a common interpretation of implied volatility readings is that higher values suggest that market participants expect larger price swings, while lower values indicate a calmer period ahead.

Another important indicator that we typically look at is the implied volatility skew, that contains information about the pattern of implied volatilities against different strike prices. And I know that this can sound a little bit too technical and dry, but the key point here is that implied skewness can also reveal some information about market beliefs regarding potential extreme moves in the underlying asset price.

For example, a higher probability of significant downside moves when there is more demand for put options, that provide protection, or upside potential in the case when there is more demand for call options.

So, in a nutshell, on a high level, option-implied indicators are often considered harbingers of market sentiment over specific time horizons. And what I would really like to emphasise here is that it’s precisely the ability to capture a snapshot of market beliefs, or distribution of market beliefs over a given timeframe, that makes them particularly suitable and interesting for studies of risk and overall sentiment surrounding major events, including elections.

JL: And I think, yeah, it’s a bit of a technical topic, let’s be honest, but the reality is I think this is something that, you know, our listeners and investors in general should get quite familiar with, simply because the market has changed quite dramatically over the past few years. We’ve seen the emergence of zero-date options, ie options that expire the same day, and all that has led to a lot of retail investors using those instruments to express a very short-term view. 

So, I think there is more and more to read by looking at option markets and, as you mentioned, implied volatility simply because there are a lot more people involved in that market and, therefore, it gives, maybe, a better sense of what the consensus really is.

Now, I want to find a bit more about your key findings in the study that you just did for Market Perspectives. Maybe, for example, do you see a specific connection between election polls, which also measure sentiments like implied volatility, do you see those two things being correlated? Do you see volatility moving in tandem with election polls?

NV: Yes, definitely a relevant question, and this was actually the starting point of our analysis that is now published in the October edition of Market Perspectives, as you mentioned in the introduction.

So, we looked into a lot of data to try to discover some patterns that might be interesting for investors. And, considering daily moves over the period of three months from mid-June to mid-September, that was our cutoff in the analysis, we compared the difference between the average polling results for the Republican and Democratic candidates with the dynamics of the VIX index, which is derived from S&P 500 options and represents, as we know, the expected US equity market volatility over the next 30 days. And this index also is commonly known as the ‘fear’ or ‘fear gauge’ index.

So, one interesting, very interesting observation is that the major spike in the VIX during this timeframe, when the index surged from 18% to 38% in just a couple of days, happened precisely at a time when Vice-President Kamala Harris was confirmed as the Democrat nominee.

Now, to make things even more thought-provoking, and I guess, as we will see, perhaps slightly confusing, this event coincided also with the shift in momentum in the polls. As a reminder, before 5th August, polls favoured the Republicans, whereas after that date Democrats took the lead. Therefore, at a first glance, when you look at the data, one might be tempted to quickly jump to the conclusion that the elevated market volatility was, indeed, related to the changes in the dynamics of the US presidential race.

However, as we know well, and have discussed this quite extensively over the last couple of months, there were actually quite a few other notable events in financial markets around that time that most likely carried significantly more weight. In particular, we remember very well the episode of the so-called growth scare that was triggered by weak US macroeconomic data, coupled with the unwinding of the yen ‘carry trade’. That was beginning of the August also. 

And to be clear, this is not to say that elections do not matter. Of course they do. And let’s be fair, this observation could be merely a reflection of the fact that the time period over which we compared the polls and the VIX was, so to say, too far away from the election date for markets to digest and use and come up with some meaningful narratives and perhaps even trading signals.

But, on the other hand, that’s all we can do when we are two months ahead of elections and there is no crystal ball to be found anywhere, right? So, considering all limitations, our reasoning was as follows.

OK, let’s see then if we can learn something from past election cycles. Is there any more regular behaviour implied volatility that can be observed historically over time periods that are a bit closer to the election date? Let’s say two months before and after the event.

And to address that question, we looked at the eight elections since 1992. So, that’s basically 32 years of data. And this period, of course, reflects a very wide spectrum of macroeconomic regimes, market cycles, geopolitical events and, let alone, right, the development of technologies that took place over the last three decades.

Therefore, it’s difficult to argue that specific investment conditions could dominate the results when we aggregate historical information across these eight US presidential elections.

So, to cut a long story short, what we found is quite interesting. On average, the VIX dynamics follows a tent-shaped pattern around the election date, meaning that implied volatility tends to rise in the two months before the election and then it gradually subsides and reverts to the pre-election levels, again, within the two-month period.

And historically the peak of the VIX index is observed somewhere around one week before, or on, the election day. Both in the pre- and post-election two-month periods that we considered, the changing level of the VIX is about 4% and, as I said, first rising and then falling.

However, the last thing I would like to mention is that we noticed a certain level of stickiness of implied volatility in the first four-to-six weeks after the election dates. Therefore, volatility comes in quicker and dissipates a bit slower over the following one month or month and a half.

JL: And to some degree, that makes sense intuitively in the sense that markets don’t like uncertainty more so than anything else, and ahead of a catalyst it’s normal to see implied volatility, or expected volatility, increase and once the event is there, and we have the result of whatever we’re looking at, in this case an election, the uncertainty is gone and, therefore, it makes sense for volatility and uncertainty to sort of dissipate.

Now, you mentioned this pattern of spiking or volatility increasing two months ahead of the election, but we have one month left now. So, maybe trying to be practical here, what do you think investors can do on the back of your analysis? Do you think everything is already priced in? Is there any opportunity there?

NV: Yeah. So, of course, a very important question and a practical one, right? But I guess it’s not easy to give that answer, but if I have to choose, right, the short answer to that question, Julien, would be, yes, mostly all these moves are already priced into option markets. 

And I say this because we actually dug deeper into option market data and looked into implied volatility and skews, not only for large caps but also for small caps and 11 US equity market sectors, so across the full spectrum. Since this is a more technical discussion, allow me, please, just to summarise our three key findings in this regard.

So, first, across all considered US equity market segments, we observed that spot one-month implied volatility is low compared to the corresponding averages over the last five years. Second, our calculations indicate that for almost all these considered indices, the expected relative one-month change in implied volatility lies in the top 5% to 10% moves, measured against since September 2019.

However, the estimated implied volatility for the periods from two weeks before and two weeks after the upcoming election, that is four weeks around 5th November, are still expected to be lower than the respective five-year averages, so there is no major spike in volatility so to say.

So, this indicates, at least at this time, that markets are pricing an increase on a relative basis. However, in absolute terms, there is no indication of any extreme positioning whatsoever. And this is further corroborated by the results of our analysis on implied skewness, another indicator that we mentioned, and that is even more technical so to say, and markets do not seem to be pricing in any significant steepening of the volatility curve.

And finally, to put all these results together and draw a conclusion, I guess my view is that the key takeaway for investors is that implied volatility might rise over the next four or five weeks, and we have actually already seen that in the last 10 days, and if history repeats itself, or rhymes to an extent, this is what we will see.

However, it does not seem that US equity option markets are too anxious at the moment, and I guess in the grand scheme of things when we think about investment portfolios, good-old diversification might actually be the best course of action in the current investment environment.

JL: Excellent. Thank you so much, Nikola. And, again, it’s a bit of a technical subject, but I think you’ve explained it very well. There are more details in your written publication, so I invite our listeners to take a look at that as well.

I do think it’s a very relevant topic. At the end of the day, what you’re doing as an investor is trying to figure out what is not priced in, and option markets can give a valuable insight as to what markets expect going forward.

Now, a few things to look for this week before we get into the US election. We’re going to get the minutes from the September FOMC meeting. Quite interesting to see how this decision to cut interest rates by the Fed came along. As a reminder, they cut by 50 basis points when most economists were expecting a smaller cut of 25 basis points, so interesting to get some insight of what the reasoning was.

We’re also going to get the September inflation data, the CPI, in the US on Thursday and some preliminary consumer sentiment figures from the University of Michigan on Friday. But, on Friday. the focus is likely to be on earnings, with the third-quarter earnings season kicking off as usual with the US banks first, in this case JP Morgan and Wells Fargo.

Now, that’s it for this week. Thank you very much for listening to us and, as always, we wish you the very best in the trading week ahead.