The New Volatility Regime
Chief Market Strategist David Lafferty on how rising rates and an overheating economy have changed the market narrative for investors.
For six days in February, volatility made a comeback. This is true whether you use the more statistically robust definition of “the ups and downs of the market” or the more straightforward definition – losing money. Almost out of the blue, equity investors were hit in the face with a bucket of cold water. The shock was that it occurred at a time when almost no one questioned the improving strength of the global economy. Then, as quickly as it came, the stress faded and stocks rebounded.
What does this episode portend for equity investors? Nobody knows for sure. Sharp corrections can be tremors that precede bigger selloffs or just natural breaks in a longer bull market. While the implications for the near-term direction of stocks are unclear, the correction has us thinking a lot about what it could mean for market volatility and investors’ portfolios.
Structural Volatility: A Failed Theory?
February’s correction has us dusting off one of our favorite theories – the idea that markets have become structurally more volatile. In simple terms, this means security prices are likely to swing more violently and more swiftly due to structural changes in the way markets function. The essence of the idea is that faster technology and trading speeds, combined with growing use of exchange-traded funds (ETFs), derivatives, and automated trading strategies, have resulted in more assets sloshing around unpredictably within the financial system. This exacerbates security price movements and increases stress on investors. Moreover, policymakers would be less able to provide intervention as fiscal deficits mount and central bankers are effectively out of ammo. This could cause future selloffs to be deeper and more prolonged.
In contrast, investors generally experience event volatility – something happens, markets react, and we understand the proximate cause of the losses. Modern examples include the “Asian Flu” in 1997, 9/11, bursting tech and credit bubbles in 2000 and 2008, and China’s currency devaluation in 2015. Compared to event volatility, structural volatility is more insidious, as selloffs could appear with no obvious catalyst, becoming more difficult to address and explain. Examples might include the S&P 500® “flash crash” in May 2010 or the US Treasury “flash rally” in October 2014 – big unexplained moves with little fundamental rationale. Our conclusion was that investors should prepare themselves for a riskier investment environment regardless of the news cycle.
Sadly, our theory of structural volatility has largely been a failure. In retrospect, central bank support has been limitless, conjuring liquidity almost out of thin air (i.e. quantitative easing) while taking overnight rates into negative territory. This extraordinary monetary support fostered a significantly better outlook for global growth. The combination of these factors – stronger growth and central bank-injected liquidity – led to a period of both historically low realized and implied volatility. While we had been expecting more volatility, we got less – much less. So much for structural volatility.
Source: Bloomberg, Natixis Investment Strategies Group, February 1, 2013 – February 21, 2018.
Past performance is no guarantee of, and not necessarily indicative of, future results.
A Technical Correction?
Then in February, the swoon began. The losses seemed to have no obvious fundamental driver, so market watchers blamed it on the sufficiently vague “technical correction.” Our best guess is that the market became temporarily spooked by fears of inflation, higher rates, less accommodative central banks, and the possibility that the global economy was so strong it might overheat. It didn’t help that equity prices had probably run up far too quickly in January.
But while this explanation is plausible, it is hardly compelling. We believe there was more at work here – most likely systematic selling by strategies that are required to de-risk into periods of volatility. In the wake of the turbulence, losses were blamed on specific portfolio strategies, including volatility deriatives, but we think this attribution is too narrow. In the years following the Great Financial Crisis – the worst environment for risk assets in more than a generation – it should be little surprise that investors started clamoring for strategies that limited downside volatility. In response to this demand, “volatility management” in one form or another has crept into almost every corner of the investment landscape. In fact, we estimate strategies that dynamically adjust their market exposure could hold as much as $1–2 trillion in AUM – before adjusting for leverage. Rather than treating volatility as an output (a byproduct in the search for return), it has become an input to the portfolio construction process. As a result, volatility effectively ricochets around the markets, forcing de-risking (i.e., selling) which creates more volatility, which forces more selling, and so on. The process can also work in reverse: Markets eventually calm down, volatility falls, strategies re-risk, and the buying pressure causes prices to rebound even more quickly.
Notice that this represents a structural change: Increasingly, assets are bought and sold based on market volatility and direction, resulting in a relative decline of assets bought and sold based on fundamentals. While it may sound archaic, at least “buy low and sell high” had the market-calming effect of buying into falling prices and selling into rising prices. Perhaps we buried the idea of structural volatility just a bit too soon.
A final word on strategies that seek to de-risk/re-risk: In spite of their potential pro-trend contribution to market volatility, some may be helpful in smoothing the ride for investors. This is a laudable goal for those with more modest risk tolerance in their quest for long-term growth of capital. Of course, no investment strategy or risk management technique can guarantee or eliminate risk in all market conditions. However, in markets we expect to become more volatile, we applaud their use. But ironically, the growth in these strategies represents a modern day “tragedy of the commons”: In seeking to better manage their volatility individually, these strategies may actually create more volatility collectively.
Closer to the Edge
The market chaos of early February has done little to change our outlook for asset class returns. Global equities may grind higher on a solid global economy and earnings outlook, but price-earnings ratio (P/E) expansion is likely to be limited. Likewise, corporate bonds of all stripes are appealing while credit fundamentals are still solid – in spite of relatively tight spreads. To be clear, our mild preference for risk assets remains completely contingent on continued global growth.
Our outlook for volatility has changed markedly, however. Improving global growth and central bank largesse effectively anesthetized the markets over the past few years, pushing returns higher and volatility lower. We think that unique period is coming to a close.
First, we believe that investor expectations have evolved in ways that have changed the market narrative. These include inflation finally picking up (albeit modestly), yields rising closer to more competitive levels, and central bank actions that are likely to be less benign. In essence, markets are simply running closer to the edge, making them more prone to random bouts of volatility.
Source: Natixis Investment Strategies Group, views as of February 2018.
Second, we fall back on our flawed but useful theory of structural volatility. Once the veil of low rates and central bank support is lifted, markets will likely experience larger, more unpredictable swings as volatility-managed strategies de-risk and re-risk. The era of super-low volatility may well be over.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
Volatility management techniques may result in periods of loss and underperformance, may limit a portfolio's ability to participate in rising markets and may increase transaction costs.
Credit spread tightening refers to a narrowing of the difference in yield between 10-Year Treasuries and lower-rated bonds.
S&P 500® Index is a widely recognized measure of U.S. stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large cap segment of the US equities market.
MSCI World Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets. It is comprised of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both U.S. dollars and local currencies. You may not invest directly in an index.
Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and are as of February 23, 2018. There can be no assurance that developments will transpire as forecasted, and actual results may vary. Other industry analysts and investment personnel may have different views and make different assumptions. Accuracy of data is not guaranteed, but represents best judgment, as derived from a variety of sources. The information is subject to change at any time without notice.
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