The volatility paradox
History tells us that periods of crisis are often preceded by periods of abnormally low volatility and complacency about risk and valuations. Are we in one such period?
It is widely acknowledged that the outlook for economies and investment markets is unusually uncertain, given the huge political changes that we are witnessing across the world. It is also widely acknowledged that most assets are expensive and most likely are priced to offer sub-normal prospective returns. Why then is volatility (the VIX) so low? History tells us that periods of crisis are often preceded by periods of abnormally low volatility and complacency about risk and valuations. Are we in one such period?
The above paradox is an interesting one that we have been contemplating recently. In our attempt to understand the paradox, we have tried to separate correlation from causality and as much as possible to go back to first principles. The first section delves into volatility and uncertainty and finds that while economic policy uncertainty is high, economic uncertainty is relatively low at the moment, which the equity market is currently reflecting – albeit this may change. The second section covers our current market views.
Volatility and uncertainty
The key to understanding volatility for equity markets is that it is directional. It falls when markets rise and rises when markets fall. The causality runs from equity market movements to volatility and not the other way around. So low volatility generally reflects an extended bull market. In other words, volatility is a lagging indicator. Given bear markets follow bull markets, the longer the bull market, all things being equal, the higher the risk of a bear market and a concurrent spike in volatility. However, all things aren’t equal, and it is market fundamentals that drive the risk of a bear market and a spike in volatility.
One market fundamental that has received a great deal of focus recently is the amount of political uncertainty. In fact, indices have been created to measure the level of uncertainty. The chart below plots the VIX against the Global Economic Policy Uncertainty (EPU) Index:
Source: Schroders, Bloomberg
The chart points to two key issues. First, historically there has been a strong relationship between the two variables. Second, there has been a large divergence between the two more recently. This chart, and ones like it, have been used to point to the vulnerability of equity markets, given that based on such measures equity markets are not truly reflecting deteriorating fundamentals. However, like understanding the relationship between equity markets and volatility, the issue of causality is important. The EPU Index is based on the relative frequency of occurrences of newspaper articles that contain the terms ‘economy’, ‘policy’ and ‘uncertainty’. So it reflects sentiment and does not clearly tell us what has driven this sentiment.
A key difference between the recent rise in the EPU Index and previous occurrences is that the economic environment, while uncertain, is on a much firmer footing. This can been seen in the below chart, which shows the number of developed economies that are in recession at any one time.
Currently the number of developed countries in recession is low. The global economy is growing at a healthy rate and potentially global growth could accelerate this year. Equity market pricing is based on the hard economic fundamentals. The risk, of course, is that the economic policy uncertainty leads to economic dislocation but at the moment this is not the view priced into markets.
Our outlook for asset classes continues to be one of low returns, as starting point valuations are somewhat stretched. While bond yields have risen and bond proxies (such as A-REITs) have fallen sharply, we still see these markets as expensive, offering minimal (if any) return over the next couple of years. These markets remain vulnerable and could post further losses.
Prospective equity returns are low in absolute terms, as all equity markets we cover are expected to provide returns below their long-run averages, albeit these are still generally higher than those expected on bonds. Within the equity universe, there are some big differences in return prospects. Australia, on our numbers, offers the highest prospective returns, while US equities in comparison have a more modest outlook. The strong performance of credit in 2016 has left the risks around credit somewhat asymmetric – not much upside but significant downside should circumstances turn against company debt.
Turning to emerging markets, we do not think that their recent underperformance has made emerging-market equities (or debt) cheap enough to justify the risks, despite the fact that we see emerging-market equities offering one of the highest expected returns in our universe. What this return forecast does not capture is the potential downside for emerging markets if things (US President Donald, Trump, the US dollar, etc.) go awry.
Markets and economies face significant risks. Risk assets have been quick to embrace the positives from Trump’s agenda. However, there are several aspects that, if implemented, would not be market friendly – protectionist policies have the potential to inhibit economic growth while boosting inflation. The rise in the anti-establishment mood, reflected in the several surprises in 2016, marks Europe as a potential source of volatility as major elections are scheduled this year in France and Germany. Another risk for Europe is that its banks are fragile.
On the economic side, we see the risk of an inflation surprise on the high side as more likely than a shock to the downside, given the relative tightness of the US labour market and the tepid response by the Federal Reserve to date of only two increases in the US cash rate. That would obviously be bad news for bond holders but it might also damage equities were the Fed to respond with higher interest rates. Also, debt levels are at record levels and will rise further if the shift to fiscal stimulus takes hold, limiting authorities’ ability to respond to any adverse shock.
We are therefore approaching 2017 from a perspective of being ‘alert but not alarmed’. This may have a familiar ring because we have argued this view for some time. While markets have not stood still over the year, we have not seen the sort of broad price action that is required to reset the market outlook. Nor have we seen enough change to fundamentals to rejig the assumptions on which our return forecasts are based.
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