The Long Europe Stock-Volatility Trade Is Going to Need Patience

(Bloomberg) -- Something unusual is happening in volatility markets: Europe’s measure of stock swings has stayed below the U.S.’s for the longest time since just before the global financial crisis.

This anomaly, which has been ongoing since March and typically doesn’t last more than a day or two, underscores an obvious trade: bet on the spread returning to positive territory, or, in other words, long volatility in Europe and short it in America.

But it’s not as simple as it sounds.

There are reasons why expected equity swings in Europe have drifted below levels in the U.S. First of all, Europe’s fundamentals have brightened, with its biggest sector -- banks -- emerging from crisis mode still awash with easy money from an accommodative European Central Bank. And then, firms that issue structured products tied to European indexes -- popular in the region -- need to hedge their exposure by selling volatility, further dampening the VStoxx Index.

“Due to the ECB news flow, we’ll get additional volatility in the banking sector next year, but in the interim, I expect that to remain muted,” said Davide Silvestrini, head of European equity-derivatives strategy at JPMorgan Chase & Co. in London.

He expects the negative spread between European and U.S. volatility to narrow, but not return to normal until next year. His team recommends a longer-term, variance-swap trade that would pay off if volatility for the Euro Stoxx 50 Index rises above that for the S&P 500 Index by December 2019.

Europe’s VStoxx first fell below the Cboe Volatility Index in mid-January, with the spread between the two gauges hitting a record low in early February, when the U.S. gauge soared amid a market selloff. The VStoxx has now been lower than the VIX every day since March 27.

Hedging flows from structured products tied to the Euro Stoxx 50 also mean its volatility is now “structurally lower,” though historical patterns suggest it will rise from current levels, said Jerry Haworth, London-based chief executive officer at 36 South Capital Advisors LLP, which invests in volatility. The products have a much smaller influence on the U.S. market.

There are still risks on Europe’s horizons, including slowing momentum in economic data and global trade tensions. And if U.S. shares slide again, Europe could suffer more, said Stephane Barbier de la Serre, a strategist at Makor Capital Markets in Geneva.

“It’s an end-of-cycle indicator; it’s not going to last forever,” he said, referring to the negative volatility spread. “The negative inflection in European macro indicators is very strong.”

But for now, European shares are rebounding. The Euro Stoxx 50 has rallied 8.9 percent from a low in March, much more than the S&P 500’s 2.4 percent gain. The region has embarked on a path to recovery, and a slide in corporate earnings estimates is finally reversing.

“There was always a bit of a volatility premium in Europe just because earnings were weaker, fundamentals were seen to be weaker,” said Ronan Carr, an equity strategist at Bank of America Corp. in London. “With the synchronized pickup in the global economy in the past couple of years, that’s fed through into earnings growth in Europe. That’s one of the reasons Europe looks a bit safer.”

©2018 Bloomberg L.P.

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