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Does the lack of volatility mean another crash is on its way?

22 September 2017

While the record low levels in the VIX are being presented as a harbinger of doom, Standard Life Investment’s Arne Staal believes it simply reflects a benign macro environment.

By Anthony Luzio,

Editor, Trustnet Magazine

Over the course of the past year, volatility in developed equity markets has declined to the lowest levels seen in decades.

Other financial markets, such as government bonds and currencies, also seem unusually calm both compared with history and in light of the geopolitical uncertainty in many parts of the world.

This has led some commentators to warn of dangerous levels of investor complacency in terms of valuations and an increased risk of a significant correction in equity markets and other risk assets.

However, Arne Staal, head of multi-asset quantitative strategies at Standard Life Investments (pictured), said these worries are misplaced and investors need to remember that market volatility is a symptom, not a cause. 

“Developed market equity volatility, at an index level, has reached record lows in 2017,” he noted. “In the US options market, the VIX index reached its second lowest level ever and year-to-date has averaged a level slightly less than 12 per cent. This can be compared with an average level of more than 19 per cent since the financial crisis. Indeed, in the past 20 years the VIX closed at levels lower than 10 per cent on only 16 days, 12 of which have occurred in 2017.”

Realised volatility 3-month moving average vs S&P 500 & Eurostoxx 50

 

Source: Standard Life Investments

Staal said that given the VIX index is widely seen as the investor ‘fear gauge’, these dynamics are seen by many as a warning sign of a lack of investor caution.

“In the popular press, the VIX index is widely attributed with predictive ability and the current low levels are presented as a harbinger of doom,” he explained – before adding that the truth is a lot less exciting. 

“The VIX index merely reflects the low realised volatility in equity prices, which in turn reflects a benign macro environment and lack of significant economic surprises.”



Some of the panic stems from the belief that the recent low volatility of risk assets has been driven by accommodative central bank policies. The suggestion is that monetary policy in the US, Europe and Japan has distorted the valuation in risk assets by providing a “floor” on valuations.

However, Staal said central bank policy is unlikely to have played a significant role in explaining the recent volatility regime, for two simple reasons: “Firstly, the post-crisis years do not indicate an unusual trend in volatility that one would expect to see if risk was increasingly transferred from investors to central banks.

“Secondly, it seems odd that volatility would reach its lowest levels just as central bank policies in the US and Europe seem poised to change tack, moving from an easing regime to a tightening regime.”

Instead, he said it is far more likely that the lack of significant macroeconomic risk events on the calendar, a lack of major economic surprises, improving corporate earnings and broadly benign global growth expectations underlie the current low volatility environment.

“It should be noted that the volatility of growth and inflation data in the major economies has been much more muted in recent years,” he continued. “One reason behind the length of this economic cycle has been the lack of major financial imbalances creating immediate stress.”

Staal pointed out that a measure of volatility itself is neither a reliable indicator of a bubble nor an impending market crash. In his view, the current low volatility regime reflects “an unusually volatility-accommodative macro and corporate environment”.

“A lack of major surprises in financial and economic data has allowed markets to price in benign economic growth expectations,” he added.

“Some gradual normalisation of volatility in the direction of average long-term levels is likely (in the absence of catalysts for a more abrupt increase in risk). For volatility to rise more structurally, we need to see developments that alter the expected path of the global economy.”



He said that some of the known macro risk catalysts that could lead to an abrupt transition to a high volatility regime include possible major government or central bank policy errors in the US, China or Europe, or geopolitical events, such as the possibility of military conflict in North Korea.

“In addition, valuations in many asset classes seem stretched by standard measures,” he continued.

“Equity price-to-earnings ratios are high, especially in the US, while credit spreads and bond yields are low. Leverage in developed or emerging market economies does not seem overly alarming.”

“However, there are country concerns, say China, or sectoral, say consumer credit, which could become a concern if interest rates spiked aggressively or the dollar moved substantially. A profits recession led by a sharp squeeze on margins, say if wages surge, would be another potential cause.”

He added that while individually none of these represent a likely catalyst for risk increases, observations of these issues will play a role in how investors react to developments that impact the current consensus.

“Market volatility is a symptom, not a cause,” he added. “Rather than worrying about low volatility, investors are better served by directly considering the implications of these different potential risk catalysts for future increases – and calculating how to diversify their portfolios accordingly.”

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