Anyone looking for a good reason not to dust off their investment crystal balls should look no further than the strange world of volatility. I’d be a very rich man if I’d have collected a measly £1 from each ‘investment expert’ who predicted that 2017 would be the year when volatility picked up. Even I thought that would be the case.
Except it wasn’t. Volatility collapsed and many key measures have now been trading at multi-decade lows. Most of us are in a state of obvious incredulity. 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.
The obvious observation at this point is that we’ve never had a better time to lock in some hedges which protect you against downside risk. The more important question is what the hell is going on? The obvious answer is that its central banks. They track volatility indices and are all still busily buying up financial assets with gay abandon. Other experts reckon that there’s something gone wrong with how we measure volatility and that the key futures markets aren’t working properly.
Frankly, its all beyond my understanding. I’ve gone so far as to give up watching the VIX for instance, as it heads south and trades in single digits. Then again maybe that is the exact point at which we should start watching out for market turbulence – when everyone else has got bored. Who knows, maybe its all just a quantum illusion and the cat really is dead. Anyway one of the best commentators on this strange state of affairs is the redoubtable Andrew Lapthorne at French bank SocGen. His New Year quant driven roundup came out a few days ago and I’ve pasted in the main narrative below. One suspects Andrew is right – the real warning signal of an impending regime shift will probably come courtesy of the FX markets.
“Those of us expecting greater market turbulence in 2017 could not have been more wrong. Not only did global equity markets perform well during 2017 (MSCI World delivered a total return of 20.1%), but they did so with such low volatility and consistency that if this were a fund, it would perhaps merit a visit from the authorities to check exactly what you were up to! MSCI World delivered a positive total return every month of the year and for 14 months in a row, 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. With such consistent performance and with a realised Sharpe ratio of over 4 times, little wonder many now simply opt to buy a passive tracker fund! Although there is no evidence that such periods of extremely low volatility increase the likelihood of a market sell-off, long periods of high asset price confidence inevitably leads to excess, courtesy of the positive feedback mechanism embedded in many risk models, i.e. the less risk they see, the more risk they allow you to take. Equally, given how low volatility is today, the ability to absorb even the mildest increase in volatility is perhaps the biggest challenge facing markets this year, given the anticipated tapering off of QE money in 2018.
“This QE money has, of course, generated huge amounts of asset price inflation and through direct or indirect purchasing of financial assets has been behind these extraordinary markets. MSCI World equity investors are (according to I/B/E/S data) now paying a 35% premium to get the same level of EPS they got back in early 2008. The US dividend is back is below 2% and at levels not seen since 2007, yet corporates are spending over 45% of their earnings on that dividend compared to just over 30% 10 years ago, and of course corporate leverage is problematic in markets like the US and China, and that is increasingly being felt in Europe. Last year was a banner year for global equities, to expect another year of extremely low volatility would be unwise. Finally we have to mention the US dollar. The DXY suffered its biggest decline since 2003, losing almost 10% during 2017 and more than 12% against the euro. This provided a significant boost to US profitability and for the US economy overall and its importance in driving equity prices last year should not be underestimated. The flipside, perhaps to be realised in 2018, is a significant headwind for Eurozone companies, which helps explain why Eurozone equities are back at May 2017 levels.”