4 minute read
While aggregate volatility of major stock indices continues to be atypically low, slowly but surely uncertainty appears to be building up again in financial markets. Investors should take note.
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.
It’s (still) all about liquidity
For now, the wave of liquidity unleashed by quantitative easing appears to be much more significant in driving financial markets. Central banks around the world bought an estimated $1.5 trillion of assets in early 2017, and – contrary to popular belief – the combined balance sheets of the US, UK, Japan and the Eurozone will likely continue to grow in 2018 as well. Meanwhile, central banks’ activism – suppressing 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 realized volatility on the S&P 500 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. Realized 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 level  – but the longer-term index level fluctuations are remarkably low.
All calm? Realized equity market volatility (1988-2017)
Average annual 60-day realized 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,” 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 destabilize markets so far, and the global macro environment is improving.
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.
“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 former US Federal Reserve Chairman, Alan Greenspan, warned of ”irrational exuberance” almost two decades ago. This is a market “running on fumes,” according to the President of the Federal Reserve Bank of San Francisco. In the third quarter, more S&P-listed companies have come forward with negative earnings guidance; 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. To
do this, the Fed plans to allow debt to roll-off as it matures, rather than reinvesting the proceeds. The strategy is to make the process gradual and predictable – in fact, so dull that it will be “equivalent to watching paint dry.”
Both the European Central Bank and the Bank of Japan (BoJ) will likely be watching closely, as they are yet to confirm their own quantitative easing (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. 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 suppress volatility, with the bank moving in market dips. Although its holdings do not make up an excessive part of Japan’s total stock market capitalization, the BoJ is thought to be among the top ten largest shareholders of most stocks listed in the Nikkei 225. 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 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
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL")
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as of October 5, 2017. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results.
The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each
Aviva Investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.
For Use in Canada
Aviva Investors Canada, Inc (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities
Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager.
For Use in the United States
Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading
advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). In performing its services, AIA utilizes the services of investment professionals of affiliated investment advisory firms who are best positioned to provide the expertise required to manage a particular strategy or product. In keeping with applicable regulatory guidance,
each such affiliate entered into a Memorandum of Understanding (“MOU”) with AIA
pursuant to which such affiliate is considered a “Participating Affiliate” of AIA as that term is used in relief granted by the staff of the Securities and Exchange Commission allowing US registered investment advisers to use portfolio management and trading resources of advisory affiliates subject to the supervision of a registered adviser. Investment professionals from AIA’s Participating Affiliates render portfolio management, research or trading
services to clients of AIA. Investment professionals from the Participating Affiliate also render substantially similar portfolio management research or trading services to clients of advisory affiliates which may result in performance better or worse than presented herein. This means that the employees of the Participating Affiliate who are involved in the management of
strategies and other products offered to US investors are supervised by AIA.
AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to:
225 West Wacker Drive, Suite 2250
Chicago, IL 60606