There are three main reasons why global markets are going through a bout of very subdued volatility, although investors need to ensure that this does not lead to a sense of complacency that pushes valuations to unsustainable levels.
That’s the view of Schroders chief economist and strategist Keith Wade, who thinks low levels of volatility can persist for some time to come – unless a geopolitical or macroeconomic shock makes a significant dent to investor sentiment.
This year has been marked by very low levels of volatility with the VIX index – often called Wall Street’s fear gauge – falling to near-records lows in recent months. The VIX’s current level is around 11, far below its 10-year average reading of 20.6.
Performance of VIX index over 10yrs
Source: Chicago Board Options Exchange
In addition, low volatility has come at a time when equities have continued to remain at elevated levels. The MSCI World index even reached a new high in June.
“The strength of equities against a backdrop of falling bond yields and elevated political uncertainty has raised the question as to whether investors are becoming complacent,” Wade said.
“Evidence of such can be found in the behaviour of the VIX index, which has recently touched new lows. The move is particularly surprising given that the US Federal Reserve has just hiked rates for the second time this year and is signalling another move in September as well as balance sheet reduction.
“We would note that although the VIX is low, markets are not entirely ignoring the risks as is often claimed. Gold, which is often seen as the ultimate safe haven asset, has performed well this year. In equity markets there has been a rotation away from the cyclicals, which benefitted from the Trump reflation trade, and back toward the high quality dividend payers.”
Wade added that there are three factors that caused the VIX to rise in the past but do not seem to be having that effect today.
Firstly, tightening by the Federal Reserve has been associated with increased volatility – shown in the ‘taper tantrum’ of 2013 and when the central bank first lifted rates in 2015. However, the VIX continued to recede when the Fed lifted its base rate this year.
The economist warned that there appears to be “some complacency” in market expectations of the degree of Fed tightening: “At present the market is only discounting one, or possibly two more rate hikes to the end of 2018. Meanwhile, the Fed's FOMC members projections [shown below as the dots] put rates at just over 2 per cent at the end of 2018.
Fed rate setters expectations well ahead of the market
Source: Thomson Datastream, US Federal Reserve, 24 June 2017
“Despite expecting inflation to remain relatively subdued we also see further rate hikes as the Fed continues to normalise interest rates. Such a view is consistent with models such as the Taylor rule which say rates should be higher given the position of the US in its cycle.”
Bodies such as the Bank of International Settlements are in support of higher interest rates, with the BIS recently saying that central banks should tighten policy “when demand is strong, even if inflation is weak, so as not to fall behind the curve with respect to the financial cycle”.
Wade added: “Financial markets are discounting a benign outcome for interest rates. This could reflect expectations of a weaker economy, or the appointment of a new Fed chair who is reluctant to tighten (perhaps under political pressure from the president). Janet Yellen's term expires next February.
“On balance though these are risks rather than the central view. We would certainly put more weight on a fiscal stimulus next year than the market given the political pressures for the Republicans to deliver ahead of the mid-term elections. Consequently, alongside a fall in the oil price, tighter policy from the Fed has the potential to trigger an increase in financial market volatility.”
When it comes to the oil price, sharp falls in the commodity in 2014, 2015 and again in 2016 caused volatility to jump as investors became worried about an increase in defaults in the energy sector. But more recent drops in the oil price have failed to lead to a spike in the VIX.
One risk to this, however, is more sustained falls in the oil price should, for example, the OPEC deal break down and the price of Brent crude drops back to $30 a barrel.
The third risk – China – also appears to be of less concern to investors after the authorities regained control over the renminbi by reining in capital outflows, Wade noted. The currency has appreciated recently as foreign exchange reserves stabilised.
“From this perspective it could be argued that volatility is low because investors are now comfortable with the Fed's tightening policy, China has clarified its position on the RMB and the oil price is more stable,” the economist said.
“We would add that the current low level of volatility today also owes something to favourable political outcomes in Europe where there has been no swing toward populism. We still have to negotiate the German and Italian elections, but so far voters on the continent have chosen not to join the UK in leaving the European Union.”
However, Wade concluded that the three factors discussed above are not the only ones that could cause volatility to jump back up.
“The next shock to markets may not be driven by the Fed, oil or China. It could be geopolitical in origin, for while political risks may have eased in Europe they are building in Asia where tensions between the US and China will rise if North Korea does not ease back on its nuclear weapons programme,” he said.
“Notwithstanding such an outcome, more conventional economic risks are not insignificant. In particular the market appears to be underestimating the potential for US interest rates to rise. The desire to normalise remains high and rates are still well below where most models would have them given where the US is in its cycle.
“However, such pressures will not become apparent until further out. Low inflation will keep the Fed cautious and the start of balance sheet reduction will probably see the Fed pause rate rises to monitor any more general tightening of financial conditions. Unless the Fed signals otherwise, the difference of opinion between the market and the ‘dots’ will probably not be resolved until spring next year. Meanwhile, central bank asset purchases are likely to continue to expand.
“In this environment investors may find it hard to resist being ‘complacent’ as liquidity will continue to drive markets with the risk that they move into bubble territory.”