Era of Low Volatility Will Unwind Formulaically
Sir John Templeton, the pioneer in global mutual funds, once said “the four most costly words in the annals of investing" are "this time is different.” That should resonate with monetary policy makers and institutional investors grappling with the causes, impacts and risks of the lowest market volatility, by far, in the era of modern finance.
As this cycle of exceptional stability grows longer, there is temptation to conclude that low volatility is a permanent characteristic of markets. This time is surely not different, however, and the risk-taking that hinges on such an assumption is highly vulnerable to the inevitable episode of market disruption.
First, let’s appreciate how substantial the decline in volatility has been. On pace to finish below 7 percent in 2017, the realized volatility of the S&P 500 Index is the lowest in more than 53 years. In the Treasury market, 10-year yields have remained within a 60 basis-point range this year, the tightest since 1965. This chart tells the story of motionless asset prices, both of the risky and risk-free variety.
Source: Bloomberg, Macro Risk Advisors
Markets that exhibit so little volatility reward sellers of financial insurance. In competing for these profits, investors push option prices and other forms of risk premiums such as credit spreads lower and lower. This process generates mark-to-market winnings for carry strategies, which then must be invested. The hunt for incremental yield in a benign risk environment has enabled the least creditworthy sovereign wealth funds, including the Maldives, Tajikistan, Greece, Bahrain, Ukraine and Iraq to raise $75 billion year to date.
We have seen this movie before. This particular showing is especially lengthy, and while there are plot twists that leave us uncertain, the end is actually rather predictable. Volatility that remains so low for so long forces investors to contemplate whether markets are experiencing permanent, structural change. If history is any guide however, market risk will unfold formulaically. The next risk-off will inevitably result from the collision of crowded trades with a bona-fide turning point in the business cycle.
Over the past 20 years, there have been many kinds of volatility cliffhangers. Instability originating in the markets for foreign-exchange (1997), swaps (1998), corporate credit (2002), mortgages (2008) and sovereign debt (2011) has ultimately spilled over into other asset classes as investors sought the safety of cash.
Although each of these events had individual characteristics, market turbulence is always the result of investors being forced to confront improper assumptions that leads to the de-risking of well-sponsored positions. Further, the force of the unwind is linked to the degree to which investors misjudged the amount of diversification in their portfolios. With this in mind, what assumptions are heavily represented in present day asset prices?
- The probability of a recession is low, corporate earnings will grow and the S&P 500 will continue to rise. Both model- and survey-driven approaches generally forecast a recession probability of less than 15 percent in the next 12 months. Among the nine strategists who have submitted year-end 2018 price targets on the S&P 500 to Bloomberg, none forecasts a decline in the index over the next year.
- Inflation and interest rates are low and stable, and with high confidence, markets believe they will remain that way. Inflation options imply only a 16 percent chance that the consumer price index will exceed 3 percent over the next year. The MOVE index of interest-rate implied volatility just reached an all-time low.
- Geopolitical risk poses little threat. Implied volatility on the South Korean won has receded to levels not observed since 2014 as investors shrug off heated rhetoric between the U.S. and North Korea.
- Equity market volatility is low and will remain that way. VIX option prices imply just a 12.5 percent chance that the fear gauge will be above 20 in three months.
- Return correlations, both among equities and between stocks and bonds, will continue to be very low, serving to reduce overall portfolio risk. OTC option prices imply only a 1-in-12 chance that the S&P 500 will be more than 2.5 percent lower and that 10-year swap rates will be 25 basis points higher in six month. Such is the nature of the strong assumption embedded in portfolios that stock and bond prices will remain negatively correlated.
The upshot is that liquid derivatives markets, where price discovery occurs efficiently each day, express exceptionally high confidence that neither earnings, inflation, correlation, volatility nor geopolitical risk will unfold in a manner unfriendly to the market. In addition, the S&P 500 price/earnings multiple has rarely been this elevated and appraisals like the well-followed Bank of America Merrill Lynch global fund manager survey show that a record number of investors are taking a higher than normal amount of risk.
Can the market keep going? Odds are that it will. Momentum is a powerful force in asset prices and we should recognize the standby capital already raised and hoping to be activated in private equity and credit strategies. Corporate CFOs and central banks remain active, one-way market participants that help buoy asset prices as well.
But investors should step back and carefully evaluate the rent versus buy trade-off currently on offer in markets. The incredibly low level of option prices doesn’t just describe a world that is certain about future outcomes. These same prices enable investors to stay long a clearly trending market and protect capital at the same time.
Just as the renter of a house isn’t on the hook for a plumbing problem, the option holder bears no responsibility for trouble in markets. Perfectly timing a market risk-off event is not possible, but prudent, risk-conscious investing through the cheapest option prices in a decade certainly is.
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December 4, 2017 at 08:40AM