Multi-Asset Insights: What does increased volatility mean for investors?
This month's Multi-Asset Insights explores higher levels of volatility and the resulting risks and opportunities for investors.
After almost two and a half years of a consistently low volatility environment, the volatility regime has started to shift significantly higher since the summer of 2015.
This has been caused by the gradual deterioration of the macroeconomic outlook and fundamental picture in the last few months.
Figure 1 shows one month implied volatility of the S&P 500 Index over the past two years and the lower/upper ranges of its corresponding high volatility regime.
As a consequence of this regime change, we have observed higher than average volatility across global assets and also more frequent volatility spikes of significantly higher magnitudes.
Figure 1: Range of volatility based on the S&P 500 Index
Source: Thomson DataStream, monthly data, February 2016
In this environment, it is worth highlighting several dynamics of high volatility regimes.
Increased contagion risks
While there is still evidence of differences in regional growth outlooks, a high volatility environment is typically associated with highly sentiment-driven market moves.
As a result, the contagion effects are expected to be stronger than we typically experience.
As shown in Figure 2, despite the different underlying economic cycles, volatility across different regional equity markets has moved more closely in tandem in the recent sell-off compared to the last few years.
Use appropriate comparators
When looking at the valuation of volatility, many investors focus on the absolute level of volatility within one market and compare this to other markets.
However, this misses the idiosyncratic differences between markets. For example, in the second week of January, the S&P 500 Index had already moved into a high volatility regime, but the Nikkei 225 Index was still in a low volatility regime.
As a result, it is important to assess the attractiveness of each volatility market relative to its own history.
Figure 2: Current levels of implied volatility against respective ranges of volatility regimes of each index
Source: Bloomberg, Schroders calculations, 1 February 2016
Potential opportunities to take advantage of delayed effects
Given the greater contagion risks associated with high volatility regimes, the lead lag phenomenon could offer opportunities for potentially cheaper hedges.
For example the S&P 500 Index and DAX Index moved into a high volatility regime in the first two weeks of January while the volatility in the Nikkei Index was relatively more subdued.
However, Japanese volatility then quickly caught up with the other markets. Such reactions offer opportunities for investors.
Place more emphasis on higher frequency data
Based on our research in 2013, we concluded that high frequency macroeconomic data or indicators are particularly valuable during high volatility regimes as they can capture more of the market dynamics driven by investor sentiment.
As a result, we would suggest paying more attention to the faster moving indicators currently when managing our option strategies.
Our analysis suggests that the current market weakness is based on weak investor sentiment rather than representing the beginning of a prolonged bear market or recession.
However, we are mindful that there is some complacency in terms of positioning in volatility markets, with investors expecting central banks to act as shock absorbers again, while fundamentals remain weak.
We therefore think it is sensible to remain cautiously positioned, and our bias is towards using lower implied volatility levels as an opportunity to add protection positions to our portfolios.