Taal selectie

volatility

Low volatility
does not mean
low risk

Pascal Blackburne & Luc Synaeghel 2017-11-10

Complacency rules in this “Goldilocks” environment of improving global activity with no flare-up (so far) of inflationary pressures. The investor mantra is that markets are expensive but no severe correction is to be expected in the near future, thanks to never-failing central bank support.

A view that was reinforced recently by the European Central Bank (ECB) decision to prolong its asset purchases at a EUR 30 billion monthly rate through at least September 2018. Coincidently – or perhaps not – ECB injections will just offset the Federal Reserve’s (Fed) planned balance sheet contraction, allowing for overall central bank liquidity growth to remain positive in 2018.

Perhaps even more importantly, the ECB elected to maintain its negative interest rate policy beyond the end of quantitative easing. So not only will liquidity remain ample but investors will continue to be pushed towards risky assets – equities in particular – in their search for return.

Much of this investor money is likely to flow into Exchange Traded Funds. Since the 2008-2009 recession, it is estimated that around USD 2 trillion in assets have shifted from active to passive strategies. Some even suggest that the 50% threshold of assets managed passively will be reached at the onset of 2018. By definition, passive investing has no fundamental basis: money is invested indiscriminately, with liquidity begetting liquidity. Equity indices thus march relentlessly up, with minimal volatility.

In turn, low volatility attracts more money into equity markets, courtesy of quantitative and systematic trading models. Indeed, the algorithms upon which rely these models translate low volatility into lower risk premium requirements – justifying a greater allocation to risky assets.

Staying on the sidelines of such a powerful self-fulfilling prophecy, fueled by high liquidity and low volatility, is a costly option. But so too could be the attempt to achieve positive returns, since the risk involved is much less innocuous than most investors would like to believe. The current context has the stuff of a bubble. Financial markets could go higher, even much higher, over the next months. But should a bad surprise occur, beware of how fast the self-reinforcing loop could also gain traction in the reverse direction.

At this point, however uneasy it makes us, we do elect to remain invested in equities, with a controlled net exposure and a bias towards Europe and Japan. The latter position served us particularly well in October, with the snap election result heralding more of Abenomics and regional geopolitical tensions having eased somewhat. Oil also remains an important feature of our portfolio allocation. After the hurricane blip, US inventories have resumed their downtrend at an impressive – and unseasonal – pace. The oil price is thus hitting year-highs, with energy stocks, particularly mid-cap shale producers, lagging some and still offering significant upside.

Central bank liquidity : the 30 billion "coincidence"

We have long contemplated – indeed written about – a possible covert coordination between central banks with respect to their respective monetary policy decisions. And the recent announcement by the ECB that it will continue to purchase assets to the (reduced) tune of EUR 30 billion per month throughout much of 2018 did little to dispel this impression.

The first question is whether such continued liquidity injections are really justified in the current European context of strengthening economic growth and inflation not so far below target? And then there is the subject of the monthly amount of purchases decided upon for the January to September 2018 period. Why EUR 30 billion? Does it represent the maximum of assets that the ECB still sees possible to acquire each month, given growing supply constraints and the statutory limits as to which instruments, in which proportion by European country, it is allowed to buy?

Or is it rather the amount just sufficient to offset the monthly liquidity to be reined by the Fed, as part of its bid to normalize monetary policy? Remember that, at its September meeting, the Fed announced the lift-off of its plan to gradually unwind its USD 4.5 trillion balance sheet by not rolling over maturing securities. The tapering has started this quarter at a monthly rate of USD 10 billion. It will be raised by USD 10 billion each quarter until it reaches a monthly rate of USD 50 billion. For the full year 2018, this implies a balance sheet contraction of USD 420 billion – or USD 35 billion per month. Which, at the current euro/dollar exchange rate, equals EUR 30 billion. We must confess to finding this equivalence intriguing.

Even if it is only a “coincidence”, the fact remains that central bank liquidity will continue to expand in 2018. Fed tightening will be offset by ECB injections, with Bank of Japan purchases – which have been all but secured by Abe’s recent victory in the snap election – pushing the aggregate measure into positive territory.

As investors, fighting the flow of liquidity that will continue to pour into financial markets, quite regardless of fundamentals and valuation, does not make for an attractive proposition. Particularly when the alternative of holding cash yields nothing (or even bears a cost).

But this does not mean that investment risk should be taken inconsiderately. Although no immediate danger appears to threaten financial markets, history teaches us that the trigger for a reversal always takes investors by surprise. Would the Fed have adopted such a long (multi-year) timeframe to unwind its balance sheet, and would the ECB have decided to continue to plough money into a strengthening business cycle, if they did not believe that the global economy and financial system remain fragile?

Protecting client assets must remain our priority, even as we strive to achieve positive portfolio returns in a zero-yield world.

The mechanics of volatility

Chart: S&P 500 index vs. its implied 1-year volatility (last 10 years) 

vol

Source : Bloomberg

Until this year, VIX readings below 10 were exceptional. Between 1990 and 2016, this widely watched measure of the volatility expected in the US stock market, also known as the “investor fear gauge”, closed below 10 on nine occasions only. For 2017, the count has already hit forty.

This string of low volatility data points reflects more than investor complacency. It has to do with the inner workings of today’s financial markets. Volatility is not just an outside measure of risk. It has become a critical input – explicitly or implicitly – for many investors’ asset allocation decisions, when not a variable upon which they make direct bets.

Take VIX futures for instance. The fact that the VIX has gone from low to lower throughout this year has spurred investors to flock to the short trade – reinforcing the downtrend in volatility. But if (or should we say when) something triggers a market reversal, the scramble to cover short VIX positions is likely to bring about a spike in volatility.

And with the currently huge (estimated in trillions) amount of assets invested through models that use volatility as a key input for their allocation to risky assets, such a spike would cause a rapid reassessment of the equity risk premium and a reduction in associated positions. Systematic buying would shift to systematic selling, all the more so since passively managed funds have gained such prominence.

Portfolio insurance is widely viewed as the amplifier (but not trigger) of the 1987 stock market crash. Volatility-based trading could well play that role when the current market rally falters.