Plain sailing if you ride out the storm

Kerry Craig

As a Kiwi, I followed the America’s Cup regatta in San Francisco Bay with interest. Watching the racing between Emirates Team New Zealand and Oracle Team USA was often infuriating, but was also reminiscent of what it is like to be an investor and how we all sometimes need to fight our natural instincts.

During nearly all of the America’s Cup final races, the US team pulled away on the downwind leg of the race, creating what looked to be an insurmountable lead over the New Zealand team. But on the return upwind leg the Kiwis caught up and the race was back on. Giving up on the race when you are behind means that you are not even in the race when things turn your way. The same is true when investing. Giving in to the urge to sell up when things get rough often means missing out on gains.

Although there have been a few bumps along the way, equity investors have enjoyed the rally in developed markets in the past 12 months and the relatively low levels of market volatility. A popular measure of equity market volatility is the VIX, also know as Wall Street’s ‘fear’ index. This index measures market expectations of volatility for the next 30 days by looking at the cost of buying and selling options on US equities. A high or rising VIX means the cost of buying options is rising as the demand for protection is increasing because investors are becoming more fearful about market movements. Conversely a low or falling VIX suggests fear levels are low or receding. VIX has its critics but is doing a pretty good job of signalling the relatively low levels of volatility in equity markets, and has been well below its long-run average for most of 2013.

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While this environment of low volatility has meant fairly plain sailing for investors, it is not the norm. In the past few weeks many of the potential market-moving events, such as the Federal Reserve’s September non-tapering announcement and the German election, have passed without too much disruption. But there are still plenty more on the horizon that could lead to increased market volatility.

German voters resoundingly opted to keep Angela Merkel in power, and her Christian Democratic Union party was only five seats shy of gaining the first absolute majority since the 1950s. The outcome of the election could be viewed as positive for Europe since the ‘eurosceptic’ Alternative for Germany party failed to gain seats in parliament. However many of the issues that were placed on hold in the run-up to the election will return to the fore. Notably plans for a European banking union, the push for further economic reform in the periphery, the level of austerity that should be enforced to meet budget deficit targets, and the impact this will have on the fragile European economic recovery.

The US fiscal position will also raise its head in the coming weeks. The US government faces a potential shutdown if Congress cannot reach agreement on a means to fund the government. This debate will quickly be followed by the issue of raising the debt ceiling, which currently stands at $16.7 trillion (£10 trillion). The US Treasury estimates the limit could be reached between mid-October and early November. While investors have been through this drama before in August 2011, and therefore believe an agreement will be reached, nothing is guaranteed and this is another potential source of volatility for equity markets in the near term.