Volatility, or the current lack of it, is a hot topic in investment circles, with the so-called ‘fear index’ in the US – the Vix – sitting at all-time lows.
The index dropped below 10 on a number of times in May and June, nearing the record low of 9.31 on December 22 1993. To put these figures into context, the average level since the Vix launched in 1990 has been 19.5, and the October 2008 high was above 80.
Commentators have suggested several reasons for such lows, including the market distortion created by the rise of smart beta strategies, widespread central bank intervention and falling correlations between individual stocks.
More importantly, thinking is now turning to whether prevailing low volatility signals a spike to come, and perhaps a bear market along with it. Speculation is also increasing about what might spark such a pick-up, with the recent US Federal Reserve rate rise and chaotic UK election both prompting little more than a blip.
The end of quantitative easing may be a contender to cause a sustained rise in the Vix, and mixed messages from central banks about the end of low interest rates drove heavy trading in June.
According to reports, several multi-asset managers are adding protection to funds in a bid to guard against future risks, suggesting low volatility signals investor complacency. While I understand that thinking, basic supply and demand suggests that if portfolio protection is popular, it will also be very expensive.
We believe current concerns about a potential spike in volatility reinforce the case for a properly diversified portfolio. Intermittent corrections of 5-10 per cent are a common and necessary function of healthy markets and suggest we are overdue such a pullback. But discounting any kind of black swan event, we are not expecting a bear market to raise its head. There is plenty of political risk out there and equities are expensive, but they remain supported while dividend yields continue to outstrip those available on bonds.
We also question the assumption that low volatility, if taken as a sign of complacency, should be seen as an automatic sell signal. Research shows low volatility can persist for a long time and, while sometimes followed by a bear market, it is far from a reliable signal. Where low volatility has led to bearish conditions, there has typically been a gradual rise in volatility before the downturn sets in.
With the twin shocks of Brexit and Donald Trump’s election victory last year, and a heavy year of election activity in 2017, no one can deny we are in an era of high political volatility and many have understandably asked why this has not fed through into the stockmarkets.
A point to make is that in contrast to previous episodes of political uncertainty (2008 and 2011-12), earnings growth and measures of liquidity have improved in recent months.
We also agree with the idea that a new form of lower-growth economic stability has emerged in recent years. This can explain much of the fall in volatility, with many firms able to achieve robust earnings growth despite little in the way of economic growth.