The turbulence seen across share and bond markets in the first half of February may have been uncomfortable for many investors and maybe even unexpected but it was hardly unflagged.
In late January, for example, as we noted in Investment markets never change. Until they do, a warning the unusually prolonged period of calm could not persist indefinitely even featured in the pages of The London Review of Books.
If it is not unfair to that magazine to suggest so, a rather more conventional place to find cautionary words on economics and investment is the twice-yearly Financial Stability Report from the Bank of England.
And sure enough, in the most recent instalment, which was published last November, you can find the following chart, showing volatility had been sitting at historic lows across a range of different asset classes.
Dispersion in implied volatilities in foreign exchange, interest rate and equity markets(a)(b)
Sources: Barclays Live, BBA, Bloomberg Finance LP, Chicago Mercantile Exchange, NYSE ICE and Bank calculations. Taken from BOE Financial Stablity Report (a) Three-month implied volatilities for exchange rates, equities and ten-year interest rates.(b) Data for S&P 500, FTSE 100 and US rates start from January 2000; data for US$/£ and US$/€ exchange rate start from August 2001; and data for UK rates start from November 2002.
It is worth pointing out there is in itself no causal relationship between low volatility and subsequent poor returns.
Low returns plus the sort of extremes of valuation that can still be seen in markets regardless of the recent sell-off makes, however, for a bad combination – not least because low volatility can lead to complacency and increased risk-taking among investors.
On which point, two further charts are also worth noting from the latest Financial Stability Report.
The first of these relates to the how the proportion of ‘lower-rated’ bonds in the sterling investment grade corporate bond index has changed over the last two decades.
In this instance, ‘lower-rated’ means bonds classed as BBB by credit agencies, which is the category just above non-investment grade or, less politely, ‘junk’ bonds.
And, as you can see from the chart below, the share of BBB-rated bonds in that index has risen sixfold from 8% in in 1998 to just shy of 50% today.
In other words, 20 years ago, investors would have been referencing an investment grade corporate bond index, the great majority of whose constituents were respectably high-grade. In comparison, today half of that index sits just one step above junk status.
The proportion of BBB-rated debt in the sterling investment-grade corporate bond index(a)
Sources: ICE BofAML and Bank calculations.Taken from BOE Financial Stablity Report (a) The chart shows the proportion, as measured by market value, of the ICE BofAML sterling investment-grade index that is rated BBB. This index can be used as a representative measure of the sterling investment-grade corporate bond market. However, the index may not capture all sterling investment-grade corporate bonds and alternative indices may contain different proportions of BBB-rated bonds.
Does that have implications for investors?
We would suggest so, here on The Value Perspective – and the Bank of England appears to agree, noting: “After adjusting for this deterioration in average credit quality, sterling investment grade corporate bond spreads look even more compressed and are at similar levels to those seen before the financial crisis.”
Certainly another contender for our regular Investment Red Flag Watch…
The other chart that caught our eye approaches things from the opposite direction – illustrating not that investors are being drawn to increasingly risky parts of the market but that they can often instinctively shun cheaper sectors that offer a better risk-reward balance.
Ahead of any fresh market downturn, might not investors be better off seeking out businesses that almost did not make it out of the last one?
After all, surely they would be far more motivated to avoid a repeat than businesses that sailed through the financial crisis with relative ease.
To put it another way, faced with a dangerous road ahead, would you rather be in a car with someone who has adjusted their driving style after surviving a bad accident or with someone who not only has never been in an accident but drives as if it has never occurred to them they might be?
That brings us to the UK’s still much-maligned banking sector and the following chart, which shows the stock of commercial real estate held by British banks has more than halved since the UK financial crisis – falling from some £160bn at the end of 2008 to around £77bn now.
This is a small but striking example of how, having had one near-death experience, UK banks are doing their utmost to avoid having another.
UK CRE (commercial real estate) debt reported to De Montfort University survey(a)
Sources: De Montfort University and Bank calculations. Taken from BOE Financial Stablity Report (a) The composition of the survey sample was altered as follows: a category for insurance companies was created in 2007, and another one for non-bank lenders in 2012. The category of insurance companies includes only UK insurers from 2007 to 2011, and all insurers from 2012 onwards. Data exclude commercial mortgage-backed securities.
Investors are, quite rightly, asking themselves where the risk is in the market – yet, worryingly, many appear to be coming to the wrong answer.