The low volatility present in today’s markets may seem at odds with the sentiment that a correction in equity, and some credit markets such as high yield, is just around the corner. However, fears of a repeat of past years’ “summer swoons” appear to be unfounded. Economic data releases have largely met or exceeded expectations, there are signs that geopolitical risks may be fading (particularly in Ukraine) and, perhaps most crucially, monetary policy looks set to remain accommodative in the near future.
The downside of the ‘melt up’ in equity markets is that this in itself has created worries about investor complacency, and that it will only be a matter of time until we are presented with a market correction. Although as John Templeton said, bull markets “mature on optimism and die on euphoria”, and it would be difficult to find anyone who truly feels euphoric about markets right now.
A common signal of low volatility – and perhaps complacency – is the CBOE VIX Index, which recently touched multi-year lows. The VIX tracks the implied volatility of the Standards & Poor’s 500 by gauging investor demand for protection from market movements, through the purchase of put and call options over the coming 30 days. Also known as the ‘fear’ index, it captures investors’ shifting perceptions nicely. A high VIX means lots of protection buying and a greater degree of fear that markets are starting to move in an unwanted direction.
So, what seems like the right amount of fear that investors should be feeling just now? At the end of May, the VIX was 11.4, well below the long run average of 20.1. Mean reversion would suggest the VIX should rise, but long periods of low volatility are not unheard of. The VIX was at low levels during the mid-1990s and mid-2000s, when US markets were in bullish territory. It may make sense to point to the S&P 500 hitting multi-year highs and say that volatility should be low, but this does not feel right given the events of the past few years, or even since the start of this year.
Furthermore, the VIX is measured against the S&P 500, which means it has the potential to miss shifts in other parts of the market or very isolated market moves. The sharp decline in biotech companies earlier in the year did not really register in the VIX, neither does the fact that US smaller companies (represented by the Russell 2000 Index) are down 3 per cent since the start of the year.
The S&P 500 performed better in May than it has done for the past three months, but again, this is not being met with whoops of joy. At the same time, the yield on the 10-year US Treasury has fallen 60 basis points this year, adding to the feeling that bond investors might know something the equity market does not.
I do not think so. The fall in yields on long-dated US Treasuries can be put down to a combination of factors. Net issuance and supply has fallen at a time of increased demand from pension funds and commercial banks, while the reversal of short positions has extended the bond market rally.
Am I concerned about investor complacency? Yes. Am I worried about low volatility? No, principally because there are good reasons for volatility – as measured by the VIX – to be low right now. While the US economy may have contracted over the first quarter of year, the macroeconomic outlook is more stable and data continues to point towards better growth over the rest of the year. Meanwhile, ultra-loose monetary policy continues to provide a level of reassurance to investors.
There are always risks to investing and volatility could spike if, say, the Ukrainian crisis escalates or expectations of interest rate rises are brought forward. For now, though, I would pay attention to Mr Templeton. The mood is certainly not euphoric and S&P 500 valuations are not super expensive, which suggests low volatility and the slow grind of equities may be with us for a little longer yet.
Kerry Craig is global market strategist for JP Morgan Asset Management
