Eran Peleg, Chief Investment Officer
After a quick July rebound from the Brexit vote sell-off (the referendum took place on June 23rd), financial markets settled back into their range-trading, low-volatility, state. This has been the state of the market for two years now, since the summer of 2014 -- only to be interrupted at times by swift, fairly unexpected, sell-offs.
Volatility should be a reflection of the level of certainty (or uncertainty) about the future. As investors feel more certain about the future, the range of possible future returns a security may deliver narrows, the dispersion of potential returns falls -- volatility drops. Similarly, when investors see the future as highly uncertain, prices of financial assets are volatile. Low (high) volatility = low (high) risk. What are the drivers of the low volatility currently characterizing financial markets, and should the low volatility of financial asset prices, and markets broadly, provide comfort to investors or should it be a cause for concern?
Global Equities (MSCI World in USD Terms)
On one hand, as J.P. Morgan recently points out, an important driver of low market volatility has been low macro-economic volatility. The current cycle of economic expansion, which started after the financial crisis of 2008, has not only been the slowest global recovery since World War II, but also the most stable one. Although growth in certain countries, like the US and Japan, has been slightly more volatile than during the 1980s/1990s, others are much less so. At a global level, growth has not been so stable for many years (see chart). Other key macro-economic variables, such as inflation, have also been steady. To most investors, economic activity data releases continue to give little cause to change basic views about the macro-economic environment – which translates into lower volatility of financial asset prices.
However, this is far from being the entire story. In recent years, market volatility has also been dampened by extremely accommodating monetary policy (zero/negative interest rates, quantitative easing, etc.) conducted by central banks -- by ‘easy money’. Despite often weak economic or corporate fundamentals, financial markets continue to be supported by a drip-feed of cheap liquidity desperately chasing returns and quickly-disappearing yield.
What will happen when easy money is taken away? We do not know for sure. But if we are to judge by the markets’ behavior during recent episodes in which monetary tightening by one of the world’s main central banks was seriously discussed or actually occurred – remember ‘taper tantrum’ in 2013 or the market sell-off immediately after the US Federal Reserve’s 0.25% rate hike in December 2015 (in both cases, global equities were quickly down around 10%) -- it is unlikely to be a pleasant experience for those over-exposed.
Do not be misled by the current low level of financial market volatility. Low volatility forced on markets by aggressive central bank action gives investors a false sense that everything is fine in the world. It masks the underlying fragility of markets characterized by low growth/profits and expensively-priced yielding bonds and equities (in a yield-starved environment). The US Federal Reserve is now expected to raise interest rates again in December. We are watching.