Our 2023 outlook for equity volatility

The rebound in equity markets from their covid lows in early 2020 led investors to protect their gains by hedging massively their positions through put options as economic conditions remained fragile despite the support of central banks. The failure of bonds to provide portfolio protection also led investors to turn to derivatives to hedge downside equity risk. As a result, in 2021 implied skew increased sharply, reaching a level not seen in decades and keeping implied volatility elevated despite a strong equity market rally. Consequently, the gap between implied volatility on the VIX index and that seen in the at-the-money (ATM) S&P 500 options index widened significantly. The same divergence was to be seen between the VIX index and S&P 500 index 30-day realised volatility.

The macroeconomic backdrop has been different in 2022, with a dramatic decline in the implied skew to levels observed in 2001 following the bursting of the dotcom bubble. The gap between the VIX index and ATM implied volatility (as well as realised volatility) has almost closed. This sharp decrease in implied skew is a result of the low demand for put options to protect downside risk. Investors have shied away from outright put options and turned to futures and put spreads strategies instead to hedge their portfolios as volatility has remained relatively elevated by historical standards, making outright OTM options relatively expensive. There has been a move to use out-of-the money (OTM) calls to hedge right tail risk. But this has not been strong enough to prevent the call skew from moving significantly downwards, just like the put skew.

In almost all recessions since 1929, markets have hit bottom during actual recessions, rarely in the year before. Volatility similarly tends to peak during recessions.

According to our macroeconomic scenario, the US and euro area economies should experience a mild recession in 2023. As a result, we expect volatility to be elevated next year—but closer to the level seen in the 1990 and 2001 recessions than in the global financial crisis of 2008. In other words, we expect the VIX index to average 25% over next year, with a potential peak of 40%. In the event of a recession, demand for OTM options should also increase, either to hedge against further market declines or to take advantage of market stress to take profits. As a result, implied skew could steepen again.