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Record low volatility could signal high market complacency

Wall Street

FT columnist David Stevenson, writes for Glint on the market’s record volatility lows and says if  “extra ordinary” low risk means steady returns, it can also mean price warping and complacency

Unless you were living in a cave over the last year, you might just have noticed that investors are in an exuberant mood at the moment. The big benchmark equity indices have nearly all peaked in recent weeks and most investors seem to be in fairly chipper mood. The global economy is humming along nicely, inflation is under control, and the US Fed is slowly but steadily raising rates.

The flip side of this bullishness for risky assets is that volatility has collapsed. This matters because equities, for instance, are what economists call ‘risky assets’: i.e. they give you, the investor, an extra return for taking greater risk. If there isn’t much risk – as there is, at the moment – then economists tend to get a bit worried. No investment can be a one-way bet, except of course government securities. History teaches us that such over-confidence usually results in financial cataclysm.

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It’s worth dwelling on volatility because it is so crucial, not least to anyone who invests in gold – the precious metal has traditionally been seen as a great hedge against market volatility. In sum, volatility within the global markets has utterly collapsed and many key measures of this market turbulence are now trading at multi-decade lows.

Most of us are in a state of obvious incredulity about this peculiar state of affairs. Last year volatility barely budged for instance even when President Trump started threatening North Korea with nuclear war. Surely the prospect of a radioactive Korean peninsula might cause some major jitters? The markets thought otherwise.

It’s quiet…too quiet?

The story of the ghost of volatility – as measured by indices such as the US ‘VIX’ – has been a truly remarkable one, constantly retold over the last few years. One of the most cogent observers of this narrative has been Andrew Lapthorne, a quant strategist at French investment bank SocGen. In a note to his clients earlier this week he summarised the peculiar state of affairs thus: “The MSCI World (equity index) delivered a positive total return every month of the year and for 14 months in a row, (while) realised daily MSCI World volatility over the year was less the 6%, half the usual rate, and the index experienced a maximum drawdown of only 2% – and if you run a regression trend-line through the year’s performance, the fit is the highest recorded! All of these are records not seen in the data since records began in 1969.”

Lapthorne isn’t the only perplexed observer. In the dying trading days of mid-late December, Hamish Preston of S&P Dow Jones Indices reminded his clients that US equities haven’t been this calm since the 1970s, while European equities are also at a decade low.

According to Preston, the average observed 1-month volatility in the S&P 500 in 2017 is “lower than in any other year since 1970 [my emphasis added]. Market participants have also seemed intensely relaxed about the expected impact of anticipated news-flow on S&P 500 constituents; 47 of the lowest 56 closing VIX levels since January 1990 have been observed in 2017, as well as two new all-time low closing levels. This environment helped the S&P 500 VIX Short-Term Futures Inverse Daily Index to a 175.63% year-to-date total return.”

What’s true for the US is also true for Europe according to Preston – he observes that “risk was the dog that didn’t bite this year” in Europe, as victories for the favourite candidates in Dutch, French, German and Japanese elections did not provide the unexpected results typical of 2016. “Without such surprises, and supported by ultra-low stock-to-stock correlations, the average monthly volatility in the S&P Europe 350 has been lower in 2017 than in any other year in the past decade”.

The chart below fleshes out this story in a very graphical form.

Average 30-day realised volatility

Average 30-day realised volatility

I also think it’s worth making another observation – on credit default swaps. I watch this market very carefully, not least as an indicator for worries about the health of the major investment banks. Again, we’ve seen some remarkable changes in this market over the last year. Put simply, pricing for these options has collapsed, as investors have stopped worrying.

Structured product provider Meteor collates the latest numbers every month and you can see the latest December stats here. What they tell is that rates on credit default swaps are near all-time lows. What’s also striking is that over the last 12 months credit default swap rates have declined markedly for all banks in the list, with most experiencing a 50-70% decline. One very final observation – the cost of insuring against a bond default by UBS – over the next five years – is now less than the cost for insuring UK government gilts.

Calm before the storm?

Whereas most ordinary investing folk don’t seem to care about this extra ordinary state of affairs, most dismal economists and their analyst peers smell a rat. They think we should care, as all this boosterism usually ends up going wrong at some stage. Lapthorne at SocGen for instance, observes that low risk markets tend to have a big knock on effect with “positive feedback mechanism embedded in many risk models, i.e. the less risk they see, the more risk they allow you to take”. As a result, investors end up chasing financial assets to high valuations – MSCI World equity investors are (according to the well-established I/B/E/S data) now paying a 35% premium to get the same level of EPS they got back in early 2008 with the US dividend back below 2% and at levels not seen since 2007. Soaring valuations also encourage corporates to buy back more shares and increase dividends – by taking on more debt. Barely a day goes by now without some giant US or UK corporate issuing dirt cheap, multi-billion dollar bonds at bargain basement rates to fund buybacks, dividends and bumper executive pay – but one thing they have noticeably not funded is more capital expenditure to pay for the better running of their company, arguably the spend most necessary to justify these high valuations.

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We shouldn’t, of course, be surprised by any of this. This is exactly what the central banks want to happen. Keep rates low and flood the market with liquidity to create stable conditions for an upturn. Mission accomplished! And there’s even evidence that the central bankers are now explicitly monitoring volatility indices as a form of macro-prudential regulation – thus the chief snapshot of turbulence itself becomes the policy tool, opening up all sorts of Heisenberg-esque quips about uncertainty.

Pricing a complicit volatility

The flip side of this is that investors are also focusing on volatility themselves through their portfolios. Indices such as the VIX (tracking ups and downs in the S&P 500) can easily be invested in via futures and exchange traded notes (ETNs). In fact, one could argue that this new asset class has become so popular that it’s actually warping the underlying market itself, producing all sorts of pricing distortions. One small example: with the VIX at record low levels, there has never been a better time to buy portfolio hedging for any big downside risk to your investment portfolio.

And, crucially, I don’t see this strange state of affairs changing any time soon, unless president Trump gets tempted by that “much bigger & more powerful” big red button sitting on his desk and decides to fry North Korea. Central bank interference in asset markets isn’t going away any time soon and interest rates will remain low. The barbarian populists at the gate aren’t even a threat, as most of them seem to be every bit as capitalistically inclined as their hated establishment peers – bar Jeremy Corbyn that is.

The big turn, when it comes, I think will come either from the FX markets or China or both. Experience teaches us that many major macro-economic crises emerge either out of excessive leverage or from fundamental imbalances in the global capital and trade system expressed through FX rates. Eventually the global financial markets do find a way of accurately pricing risk, and it usually ends up hitting FX rates. As always, it’s worth watching the dollar – dollar spot rates lost almost 10% during 2017 and more than 12% against the euro. That weak dollar has helped the US economy surge forward, but at what cost to the stability of the global financial system? Alternatively, we could see a sharp slow down in China, resulting in mayhem in the FX markets. But when a ‘regime change’ comes, watch volatility spike – the greatest show on earth will then begin again.

David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He is the editor in chief of AltFi, has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY.

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