While aggregate volatility of major stock indices continues to be atypically low, slowly but surely uncertainty is building up again in financial markets. Investors should take note.
4 minute read
The psychology of markets never fails to befuddle. Apparent risks, such as the nuclear threat from North Korea or the withdrawal of major central bank stimulus, are being shrugged off in a matter of minutes or, in the case of the latter, barely register in equity market calculations. This raises fundamental questions about how markets are functioning. “It seems as if the windows of risk aversion have narrowed. The markets fell after the Brexit vote in 2016 but then took just 14 days to recover; the recovery after Trump’s election took about 12 hours and the unsuccessful Italian referendum took around 10 hours” says Trevor Leydon, Head of Investment Risk and Portfolio Construction, Aviva Investors.
Political risk has clearly not dented enthusiasm for equities. Instead, the market is struggling to digest the new realities. “Where we see the rise of populism, nationalism and protectionism, the risk of a non-collaborative outcome between nations – economic, political or military – has probably increased,” adds Leydon. “But investors have not collectively had much time to understand these new dynamics.”
Part of the problem is the difficulty in accurately framing and assessing tail risks. “Our brains are not wired to think about things that are really rare,” explains Professor Howard Kunreuther from the University of Pennsylvania. “What we’re really good at is learning about tasks and decisions that we make every day.” Events that might never occur, that occur just occasionally, or where feedback loops can amplify impacts in unexpected ways, tend to be pushed to the analytical sidelines.1
It’s (still) all about liquidity
For now, the wave of liquidity unleashed by quantitative easing is much more significant in driving financial markets. Central banks around the world bought an estimated $1.5 trillion of assets in early 20172, and – contrary to popular belief – the combined balance sheets of the US, UK, Japan and the Eurozone will continue to grow in 2018 as well. Meanwhile, central banks’ activism – supressing long-term borrowing costs and sovereign bond yields – has contributed to a broadly stable macro environment and dampened stock market fluctuations.
“In 2017, the average annual 60-day realised volatility on the S&P500 has fallen to its lowest level since 1965,” says Ben Maynard, Head of Derivative Strategy at Aviva Investors. “Similarly low volatility has been experienced in other equity indices, although not at quite such historically extreme levels, with the Nikkei and Eurostoxx touching the lowest levels on the same measure since before the Financial Crisis in 2008. Realised volatility on the MSCI Emerging Market index is near its previous cyclical low in 1996 as well.”
These aggregates conceal a lot of dispersion in returns at the stock level, and more frequent volatility spikes at intra-day level3 – but the longer-term index level fluctuations are remarkably low.
All calm? Realised equity market volatility (1988-2017)
Average annual 60-day realised volatility
Risks in a bipolar world
Nevertheless, the current liquidity-driven environment does not imply an absence of risk. “The world economy is currently ‘bipolar’, in the sense that there is a very short distance (in volatility space) between the current (good momentum, low volatility, high speculation) environment, and a global recession induced by a risk perception spike,”4 suggest Professors Ricardo Caballero and Alp Simsek of MIT.
In their view, that spike is most likely to be precipitated by a geopolitical shock. They point out that authorities have more limited tools with which to respond to shocks where interest rates are already low, and while growing income inequality has led to a lower propensity to consume. The current risks might be difficult to appreciate at a time when political events have clearly failed to destabilise markets so far, and the global macro environment is improving.5
Bye bye liquidity, hello volatility?
If it is not geopolitics that causes volatility to spike, then the withdrawal of monetary stimulus is another possible culprit. The US’s rate hiking cycle is under way, and another increase in the base rate is expected by the end of the year.6
“Investors have become accustomed to central banks stepping into the market. If we had a 10% drawdown in equities, investors might simply expect central banks to become more dovish,” says Ahmed Behdenna, Senior Multi-Asset Strategist, Aviva Investors. “But as we move out of the accommodative period, the put option is eroded.”
Significantly, change is happening while equity markets are already generously valued. US stocks are trading well above the level at which Alan Greenspan warned of ‘irrational exuberance’ almost two decades ago.7 This is a market “running on fumes”, according to the President of the Federal Reserve Bank of San Francisco.8
In the third quarter, more S&P-listed companies have come forward with negative earnings guidance;9 those that have used the period of low interest rates to borrow extensively to fund share buybacks or simply maintain dividends could be exposed as interest rates head higher.
These sensitivities do not seem to be fully reflected in some current allocations. “Equities see no clouds on the horizon as it stands,” says Charlie Diebel, Aviva Investors’ Head of Rates. “That, if anything, could be where the risk to markets really lies, in that a significant risk-off period would be contrary to a large degree of positioning sitting latently in the market.”
Meanwhile, the Federal Reserve is also leading the charge to shrink its balance sheet.10 It will now allow debt to roll-off as it matures, rather than reinvesting the proceeds. The plan is to make the process gradual and predictable – in fact, so dull that it will be “equivalent to watching paint dry”.11
Both the European Central Bank and the Bank of Japan (BoJ) will be watching closely, as they are yet to confirm their own QE exit strategies. Exit might be particularly complex in Japan, where the central bank has used QE to buy shares via Exchange Traded Funds (ETFs) since 2010.12 Elsewhere, most QE-related asset purchases have been focused on fixed-income assets.
By pouring around six trillion yen into Japan-listed ETFs annually, the BoJ has certainly helped supress volatility, with the bank moving in market dips.13 Although its holdings do not make up an excessive part of Japan’s total stock market capitalisation, the BoJ is thought to be among the top ten largest shareholders of most stocks listed in the Nikkei-225.14 In this instance, the BoJ stands apart from the other major central banks as a significant stock holder in its own right.
Investing in higher volatility regimes
With these layers of complexity, Leydon’s believes current measures of volatility fail to convey the true level of uncertainty in financial markets. “If you think of an option as a gauge of fear, the markets are currently saying there is not much risk,” he says. “But if you ask people individually about the risks that they perceive in the next six to twelve months, they may have a larger degree of anxiety. What we know from risk models and technical analysis is that a tipping point is likely to be reached where volatility will naturally increase.”
This has important investment implications. Although higher volatility is not directional – it does not necessarily imply that the trend in asset prices will be either higher or lower – it would require investors to look at the world through a different lens.
While volatility has been structurally low, a low-volatility mentality has crept in, supporting moves into some esoteric and higher yielding parts of the market. A step-change in volatility regimes might mean moving away from the asset classes that it made sense to hold in the old world of the Bernanke put. Investors should take heed.
1 University of Pennsylvania. A framework for risk management of extreme events. Howard Kunreuther. 2010
2 Bank of America Merrill Lynch. 9 June 2017
3 Economic Policy Uncertainty Index. Summary of results. Daily change in the value of the S&P 500 index (+/- 2.5% or more) has increased relative to the average since 1980. 26 September 2017
4 Risk intolerance in the global economy: A new macroeconomic framework. Ricardo Caballero and Alp Simsek. 30 August 2017
5 International Monetary Fund. World Economic Outlook Update. July 2017
6 Bloomberg. Fed maintains rates, maintains forecast for one more hike. 14 June 2017
7 Bloomberg. Some Fed members are getting worried about stock valuations. 6 April 2017
8 Reuters. US stock market ‘running on fumes’, Fed policymaker says. 27 June 2017
9 Factset Earnings Insight. 11 August 2017
10 Bloomberg. Can the Fed unwind without unnerving markets? 20 September 2017
11 Bloomberg. Fed eyes tame balance sheet taper after tantrum error. 20 September 2017 Patrick Harker, President of the Phildelphia Fed.
12 Bloomberg. Japan's Central Bank Is Distorting the Market, Bourse Chief Says. July 19, 2017
13 Bloomberg. What Should the BOJ Do About Its Towering ETF Pile? Nothing. 12 April 2017
14 Bloomberg. Japan’s ETF shopping spree is becoming a worry. 17 July 2017
