Has the period of low volatility come to an end?Feb 16, 2018

 

Was that it?

The prolonged environment of low volatility was helpful to some investors who were able to boost their returns by taking on more risk. As my colleague Stephen Lingard noted in our previous article, some of those investors who were too complacent were severely impacted by that sudden spike in volatility earlier this month. Now, with equity markets having regained some ground, many investors are asking, “Was that it?” Our answer: we think that there are a number of reasons to expect further volatility. In particular, there are a few possible triggers that could lead to a sustained period of higher than recent average volatility with potential adverse effects on risky assets.

Trigger # 1: Changing monetary policy

The removal of the extraordinary monetary support measures by central banks is having an impact on volatility through higher bond yields. Improving global economic growth and inflation dynamics with fiscal easing being piled on are putting pressure on the US Federal Reserve and other central banks to reduce their easing programs and normalize interest rates. In our view, the quick rise in US Treasuries yields was the catalyst that set off the technically driven spike in volatility most recently.

Trigger #2: Stress in credit markets

A tightening of credit conditions, owing to higher interest rates, may also ignite a change in volatility trends. Higher rates increase the debt-repayment burden of companies, and therefore make it more expensive for firms to issue debt for share buybacks. That’s why share buybacks tend to slow down substantially when rates move higher. Consequently, a significant drop in share buyback activities will remove one of the key pillars that have been supporting equity markets and subduing volatility.

 Trigger # 3: Geopolitical risk

Lastly, a resurgence in market volatility could be sparked by negative geopolitical events. Currently, we’ve seen a bit of a detente in geopolitical risk emanating from North Korea, with the nation using the Winter Olympics as an opportunity to play nice with its neighbours, but there are various potential flashpoints still on the radar. With the upcoming Italian elections, Brexit and US mid-term elections as just a few potential 'known' triggers, geopolitical risk has the potential to boost volatility at any time.

The lull before the storm

With no shortage of triggers that could spark higher volatility, we think investors should consider preparing for such an environment. For additional perspective, we turn to a 2017 white paper published by the Swiss Finance Institute (SFI) titled Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles. The paper’s authors observed that in approximately two thirds of the 40 financial-asset bubbles that they examined, crashes followed a spell of lower volatility, which the researchers termed “the lull before the storm.” 

Positioning for high volatility

So what do investors do? Only time will tell if this most recent period of low volatility foretells an impending storm. A persistent rise in market volatility could trigger more frequent and deeper downturns in risky assets.

However, although we expect to see higher volatility than we experienced in the past few years of abnormal tranquility, we believe solid economic fundamentals, strong corporate earnings and supportive fiscal tailwinds suggest a moderate “risk-on” approach within our portfolio allocation. The current market cycle is long in the tooth, but not finished yet, in our view. Therefore, some caution in certain areas is warranted. Due to richer valuations and less attractive expected forward returns, credit markets are one area in which we would gradually decrease exposure in the coming quarters to increase the quality of the fixed income side of our portfolios.

 

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.