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Low volatility finds its own cure

Steven Wieting

By Steven Wieting

Chief Investment Strategist

February 9, 2018Posted InInvestments and Investment Strategy

At the speed of light, machines trading securities took markets where long-term investors likely never would have in the final hours of 5 February.  The Dow Jones Industrial Average, the world’s oldest continuous stock market value gauge, fell 1100 points in an hour and 1700 points intra-day.  After another strong report on US business activity this morning, we simply don’t accept “good news is bad news” as an explanation.

 

According to Citi trading desks and media reports, dedicated volatility-selling funds (and other investors following the same strategy) were forced to deleverage, buying back positions in securities and derivatives that others would use to hedge declines in share prices.   Trading relationships (algorithms) based on a wide range of prices resulted in a rapid liquidation of cash equities, likely at prices some owners never would have expected.

 

As figure 1 shows, implied volatility in US equities (half of the value of global benchmarks) briefly spiked up to levels last seen in 2009. But no other asset classes seem to have been impacted anywhere close to the same degree. This is an important observation, as there is only one economic outlook. That outlook impacts all asset classes to some degree, and thus implied volatility across asset classes tends to be highly correlated over time.

 

Even more importantly, if the past day’s decline in share prices was related to some undiscovered economic weakness, credit markets would feel the impact too.  As figures 2-3 show, equities and credit markets are inextricably linked, even over long-term measures.  Yet credit markets have felt much less weakness than equities in the past week, and far less than during the fundamental challenge credit markets faced in 2015-2016 as the oil price collapsed.

 

Figure 1: Cross market volatility: US equities, interest rates and foreign exchange

Source: Haver Analytics and Bloomberg as of 6 February 2018.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

 

Figure 2: High yield credit spread and S&P 500 volatility

Source: Haver Analytics, Bloomberg, and The YieldBook as of 6 February 2018.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

Figure 3: High grade (BBB-rated) credit spread and S&P 500 volatility

Source: Haver Analytics, Bloomberg, and The YieldBook as of 6 February 2018.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

 

In line with our Outlook for 2018, we expected a trend rise in market volatility on changes in central bank policies this year.  As QE policies wind down, we expect the competition for savings from governments to reduce equity and credit returns as investors are forced to finance governments at higher yield levels.  However, we believe equity markets have fallen too much in the past two days for this to represent the “toll” bond markets will charge for “peace” between these asset classes.

 

“Why own any bonds?” was a typical question of recent months as equities soared. At the peak thus far this year, US Treasury yields rose 40 basis points, generating moderate losses for long-duration bond holders. Still, we believe US fixed income serves an important role in portfolios.  While we underweight global fixed income by four percentage points in a medium risk portfolio, we overweight both US high grade (municipals) and US high yield bonds given poor yields in other developed markets.

 

We believe equity market volatility will likely subside when investors feel more certain they understand the likely range for US Treasury yields.  Notably, the marked absence of equity volatility since mid-2016 likely led certain leveraged investors to risk too much in order to earn tiny yields in options markets, selling volatility.  We would now expect volatility to show a higher expected range for asset prices going forward, in line with our 2018 theme “exploiting volatility” (please see Outlook 2018). 

 

This does not mean a US recession is imminent.  Only 3 of 23 US market corrections of more than 10% in the past 30 years have been associated with recession.  Greater volatility than the past two years is the norm.  Drawdowns not associated with large earnings declines during recessions tend to be reversed in a time frame close to averaging one quarter in duration. This compares to an average near one year for post-World War II recession periods.

 

Sadly, as we noted in a past year theme called “the liquidity trade-off,” investors should not come to believe markets will always be smoothly functioning and liquid.  Pricing during periods of market distress may be highly inefficient.  Even well-developed equities markets exhibited this to some degree yesterday.  We would not expect investors to immediately forget.

 

Global bond markets have reacted to equities to some extent today, selling off as US equities stabilized.  Markets have still to fully ascertain what has happened, and it will take days or weeks to re-establish a clear trend.  The speed of the selloff does make us suspect that equities will find a bottom level relatively quickly.  The case for this will be aided if firm economic data and moderate inflation are reported, as we expect.  We are highly doubtful of the story that bad economic news - which forestalls interest rate pressures - would be greeted with greater equity market cheer.