Perspectives - December 2011

2012: mixed outlook of reflation hopes and deflation fears

Long volatility in 2012

In arriving at scenarios for our tactical asset allocation for 2012, our team of macroeconomic analysts have sought to evaluate how the main asset classes are likely to perform depending on differing levels of volatility. Volatility is generally expressed in terms of the VIX Index that measures expected volatility on the S&P 500, the index of US stocks. This benchmark is particularly significant, since it has a major bearing on the pricing and correlations of asset classes. Christophe Donay offers readers some informative insights into its workings in our Topic of the Month article (see page 12).

By Yves Bonzon

Chief Investment Officer

Pictet Geneva

Three main volatility modes can be identified:
1. Calm – standard cycle: VIX below 15%
2. Average – cycle with some risk: VIX between 15% and 25%
3. High – systemic risk: VIX above 25%

In reality, the VIX represents the price of liquidity in markets at any point in time T. It influences not only a number of significant factors such as yield spreads which, in turn, affect equilibrium pricing levels for equities – but, above all, it determines which investment strategies are likely to deliver the best returns, depending on the volatility regime itself and on shifts from one mode to another. Understanding the impact volatility can exert on the various asset classes forms a key stage in constructing both strategic and tactical asset allocations.

Ideally, once the impact of volatility has been grasped and factored into models, we should be able to incorporate some prediction of how volatility is likely to evolve in the quarters ahead. Among the range of barometers we use to make decisions on the tactical allocation, our proprietary leading indicator for the VIX is currently pointing towards a steep rise in volatility for 2012: the trend might not be a linear progression, but there is no mistaking its upward direction. One small aside here though: equities can rise even with the VIX climbing, as happened between 1998 and 2000. Nevertheless, the indicator is unambiguously signalling to us that the markets are heading for an eventful and turbulent 2012 against the backdrop of the continuing debt crisis, further deleveraging in the West and constant swings between deflationary surges and reflationary initiatives from policymakers. Given this highly unsettled outlook, according a sizeable weighting to tactical strategies would seem to make more sense than ever. Lastly, in the sphere of alternative strategies, we will seek to minimise exposure to those that involve selling volatility, either explicitly or implicitly.

I would like to take this opportunity to thank all our clients and business partners for their loyalty and support over the past 12 months. All that remains for me to do, on behalf of the whole of the Pictet Wealth Management team, is to pass on our best wishes to everyone for the end-of-year festive season and for the New Year ahead.

This comment is the introduction to our financial publication Perspectives, "2012: mixed outlook of reflation hopes and deflation fears", December 2011 edition.