The unusual calm in global financial markets over the last few years is unlikely to return but investors should welcome rather than fear the prospect of higher volatility, says Peter Fitzgerald.
4 minute read
Most people think of the far ocean as a terrifying place of unrelenting storms, mountainous waves, and screaming winds. But professional sailors fear the doldrums even more. In this utter stillness, either side of the Equator, yachts lie for days on end, “as idle as a painted ship upon a painted ocean”, as the Rime of the Ancient Mariner says.
Investors, too, have experienced an eerie quiet in recent times. Normally the price of financial assets gyrates, sometimes violently, as investors determine how much a stock or bond is worth. Various factors, including the economic and political background, can influence valuations. Specific issues, such as the outlook for profit growth, also play a role in determining the price of financial assets. Over the past decade, however, particularly the past two years, the volatility of the price of financial assets has fallen to remarkable lows.
So why has this happened? Faced with two major crises – the global financial crisis and the European sovereign debt crisis - central banks around the globe adopted extraordinarily accommodative monetary policies, including Quantitative Easing (QE), to stave off the threat of a repeat of the Great Depression of the 1930s. The cost of borrowing fell to all-time lows and trillions of dollars gushed into the financial system.
This time really is different
The spike in volatility seen earlier this year is likely to prove a harbinger of both higher levels and more frequent bouts of volatility as the era of super easy money draws to a close, and policymakers focus on countering inflation rather than deflation.
Concern that global growth was too fragile to absorb any monetary tightening prompted previous market wobbles, with central banks quickly stepping in to smother the market turbulence.
Today, investors are alert to signs that growth is set to rise to levels that trigger inflation and faster-than-anticipated increases in interest rates. That was certainly the case in February, with robust jobs data and strong wage growth in the US unsettling markets and causing stocks to sell off1.
Given that the broad-based, synchronised economic upswing that began a year ago shows no signs of easing up, we foresee volatility rising back to more normal levels as stronger growth, percolating inflation and a gradually tightening of monetary policy take hold.
The economic recovery is at its strongest in the US, where the Federal Reserve is leading the way in the gradual removal of policy accommodation, with three further rate hikes expected this year. Other central banks are likely to move towards tighter, rather than looser policy. In the euro-zone, we expect asset purchases to end in September. If core inflation in Japan rises above one per cent, we see the potential for the Bank of Japan to review its policy of yield curve control policy, whereby it keeps the yield on the 10-year government bond at zero.
Figure 1: Quantitative easing flows set to turn negative in 2019
The outlook for the Bank of England (BoE) is dependent on developments in the Brexit negotiations, which have the potential to move policy in either direction. However, BoE officials recently suggested that interest rates may rise higher and faster than anticipated if the economy remains on track2. Elsewhere, there is potential for rate rises in Canada, Australia, New Zealand, Sweden and Norway this year. The global trend is clear.
Exploiting the regime change
QE has resulted in lower yields all along the curve, reducing the cost of borrowing as was intended. As central banks retreat from QE, we would expect yields to move much higher than today, curves to steepen and volatility to increase.
Strategies can be implemented through options that should benefit from both a sell-off in long-dated rates and any pick up in volatility. Payer swaptions, for example, give holders the right but not the obligation to enter into an interest rate swap at a prescribed date in the future: at this point the holder pays a fixed rate of interest, agreed today, while receiving a floating rate, which would be the actual rate of interest subsequently charged in the market. These options could therefore deliver a positive return in an environment where yields on US treasuries rose higher than the market had priced in at the time the swap rate of interest was agreed. In addition, any increase in volatility should also push up the value of the option that gives the holder the right to enter into this swap.
Other strategies can also benefit from higher volatility. One example would be a long position on volatility in stock markets such as the Nikkei, Euro Stoxx and HSCEI Index paired as a “relative value” trade against short positions on volatility in the S&P 500. Typically, the S&P 500, by virtue of the greater number of constituent stocks and diversification across sectors, is less volatile than the other indices against which it is paired. This should, of course, be reflected in the market pricing of expectations for future volatility. However, during periods of low volatility, investors can become complacent and misprice risk. This provides a window of opportunity to implement these relative value trades. Should markets subsequently experience a sell-off, the losses registered by being short S&P 500 volatility will be much less than the gains from being long volatility on more cyclical indices. As a result, when the market encounters bouts of turbulence, this strategy should deliver positive returns that offset losses suffered elsewhere in a portfolio.
Under full sail
There are many reasons why investors should welcome rather than fear a return to more normal levels of volatility. It is a sign that the global economic recovery has become self sustaining and that accommodative monetary policies have done their job.
It also provides a healthier environment for the global economy since in the long run it will lead to a better allocation of capital. That’s because the hunt for income has dominated investors’ thinking in a low volatility and low yield world, and they may have become careless about the risks that they are taking on. Higher volatility should mean risk is priced more appropriately.
Finally, just as ocean-going yacht crew look forward to moving out of the doldrums and into livelier waters where races are won and lost, strategies can be implemented that should benefit from higher inflation, steepening bonds yields and a rise in volatility.
Bucking the trend: S&P 500 leads volatility spike
The market gyrations seen in February were unusual in that the S&P 500 proved to be more volatile than indices such as the Nikkei 225, the Euro Stoxx 50, and the Hang Seng China Enterprises Index (HSCEI).
Typically, the S&P 500 experiences much lower levels of volatility than other indices. In times of stress it also benefits from the tendency of investors to seek out the safe haven of US assets. However, this time round many exchange traded funds (ETFs) were positioned in the expectation that the volatility of the S&P 500 would remain low. When volatility rose sharply, these ETFs had to unwind those positions, exacerbating volatility. Nevertheless, we anticipate the S&P 500 will return to its position as a lower volatility index relative to others.
February’s volatility had a predictable impact on asset classes. Equities were the worst-affected, while bonds suffered least. Fixed income volatility, as measured by the Merrill Lynch Option Volatility Estimate (MOVE) Index, spiked to a 10-month high, while equity volatility, as measured by the VIX index, jumped to four-year highs. Equities tend to lead any spike in volatility because they have a much greater potential for significant capital gains or losses than fixed income.
In future, currency volatility could also pick up as the outlook for interest rates around the world diverges. The Australian dollar certainly had an eventful year in 2017, for example, moving from a low of $0.7208 to the US dollar to as high as $0.8110 before ending the year just above $0.78003. The prospect of higher interest rates in the US at a time when borrowing costs in Australia are likely to remain at record lows is exerting downward pressure on the Australian currency. Further volatility has been seen this year on the back of disappointing economic data from Canberra4.
Figure 2: Volatility of fixed income and US and European equities, 2015-18
1 ‘US Adds 200,000 Jobs; Wage Growth Best Since Recession’, Wall Street Journal, February 2018
2 ‘Bank of England hints at earlier and larger rate rises’, BBC News Online, February 2018
3 ‘Australian dollar/US dollar exchange rate’, Bloomberg, March 2018
4 ‘Australia's economy grew by 2.4 per cent in 2017, below expectations’, ABC News, March 2018