Comparing current market volatility with 2008. Is this crisis already over?

Mats Ehnbom, FRM and Senior Manager in our GRC Advisory Area, compares what we know about the current market volatility with the Financial Crisis of 08/09:

The equity market bull run, lasting over a decade, ended abruptly in the end of February 2020 as the Corona virus epidemic started spreading outside China. At times, with daily equity drops above 10%, the VIX index, in media called the Fear Index, spiked to levels not seen since the last financial crisis 2008. The VIX Volatility represents the market’s expectation of 30-day forward looking volatility of SP500 index options, but it can also be a measure of the general risk appetite in financial markets. All levels above 40 signals very low risk appetite, and levels over 60 are considered extreme.

On March 16th 2020, as SP500 dropped nearly 12%, the VIX index spiked to 83, the highest level since its inception in 1990. Since then, markets have bounced back significantly and the VIX index is returning to more normal levels which, at this point, may indicate that the market does not anticipate the deep global recession that was feared amidst the volatility spikes.

Figure 1: VIX Volatility and SP500 return measured from 90 days before the peak in volatility 2008 and 2020

So, when comparing the market volatility between the current situation and the crisis 2008 – Is there reason to believe this financial crisis will be less severe? Both crises started in the same manner, with events that were initially underestimated. In 2008, there were clear signals that the subprime market was about to collapse prior to the failure of Lehman Brothers, but the event still shocked financial markets leading to the distrust between banks that worsened the crisis.

The outbreak and subsequent spread of Covid-19 outside of China was identified as a risk at an early stage, yet still the extent of the spread and its implications on the global economy shocked the markets.

However, there are some interesting differences in the volatility pattern between the crises. In 2008, the level of the volatility was higher to begin with, and there were several different shocks to the market during the crisis. This time, volatility has been at low levels for a long time, and the abrupt start of the corona crisis looks, at least for now, as a one-time shock. The duration for which the volatility index has been above 60, indicating very stressed markets, was much longer in 2008 than we have seen so far this time.  In 2008, promises of liquidity injections from Central Banks were to begin with not enough to calm the markets leading to waves with volatility spikes. This time Central Banks have been more proactive with massive stimulus and the phrase “whatever it takes” as the antivirus mantra which have calmed the markets.

Macro economists often talk about recession shapes. In a V shaped recession, the economy suffers a sharp decline, followed by a strong recovery. W, U or L are other ways of describing the shape of a recession. There are a few factors that suggest that recession will be V shaped this time. For one, the virus itself, where its fast spread might indicate an equally fast decline. Another point is that the confidence for the banking system is much better this time as banks are in a stronger position as a consequence of the policy measures as implemented by the regulatory bodies world-wide. The cost of insuring against credit losses to American and European banks, measured as the spread in Credit Default Swaps (CDS), have risen sharply during the year, but are still far below the levels that were seen in 2008, implying that the confidence in the banks is still strong compared to last the crisis. In this sense, the Covid-19 crisis is not yet a financial crisis, but rather a recession in both supply and demand affecting especially smaller companies and the retail industry. Large companies listed on major stock exchanges are so far less effected.

In conclusion, this crisis is from a financial view evolving at a much faster pace than in 2008. A stronger and more resilient financial system and the experience from Governments and Central Bankers, reacting much faster and stronger gives hope for a “V-covery”. What is still an area of deep concern is the speed at which consumer confidence and growth wanes from the impacts of job losses. But even though there will be a recession, with IPO’s stalling, and some startups having to close down, those who waited for an 80% drop in equity markets to time “the trade in a lifetime” may have to wait a bit longer.