This could be a year of asymmetry, as the gap between implied and realised volatility persists.

We expect monetary policy to put downward pressure on realised volatility, as the Fed fund rate hikes have not yet started and there is an historical lag between Fed tightening and increased realised volatility. Nonetheless, inflation expectations in 2022 should not have a meaningful impact on realised volatility as we anticipate neither deflation nor hyperinflation.

The need for equity protection has increased in line with the strong stock-market gains in recent years, including outstanding returns in 2021. Classically, this has been achieved by a balanced approach, mixing equities and long-term government bonds, which have shown a negative correlation since the late 1990s. However, because the recent rise in inflation has been challenging the diversification benefits between equities and bonds.

As a result, most portfolio protection has been coming through derivatives markets, translating into high put / call ratios on indices, elevated volatility skews on options and an increase in the price of puts relative to calls. This trend is expected to persist, especially given our constructive view on equity markets and persistent inflation concerns in 2022. Strong before the 2018 short-volatility squeeze and again 2020 pandemic, there has been no revival in gamma flows, so these are not putting downward pressure on implied volatility. Despite the strength of equity markets up in 2021, implied equity volatility remained range bound between 15 and 25% on the S&P 500 last year, except at the beginning and end of the year—although the current Omicron variant has led to higher volatility.

In short, we have been seeing a widening gap between implied and realised volatility, with increased recourse to derivatives to hedge equity risk leading to an usually big gap between implied equity volatility and realised volatility. Our core scenario is for average realised equity volatility of 8-10% in 2022 on the S&P 500 and for average implied volatility of 14-17%. However, volatility spikes above this range are to be expected, depending on the volume of negative surprises.

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Jacques Henry and Djaafar Aballeche, Pictet Wealth Management.