Steady economic expansion and strong corporate profit growth, along with low price correlation across individual stocks, have driven realized stock market volatility to record lows. In addition to these shorter-term drivers, three long-term factors may also be contributing to this period of extended low volatilitythe post-crisis financial regulation regime, a decrease in competitive forces, and a low corporate investment rate. These phenomena help explain both persistently low day-to-day volatility as well as the recent propensity for infrequent volatility spikes, such as the one associated with Brexit, to be unusually brief.

Financial Regulation
Key aspects of post-crisis financial reform include reducing leverage, improving capital quality at systemically important financial institutions, and improving transparency. It’s possible that compliance with the new regulatory regime has resulted in less uncertainty about the follow-on effects of any negative market events, which could otherwise bring a shock to the financial system.

The influential economist John Maynard Keynes’s "paradox of thrift" helps to illustrate this concept. The paradox of thrift describes how, when people fall on hard financial times, they rationally become thriftier. When a lot of people fall on hard times and everyone becomes thriftier, a recession can become a depression as economic activity winds down.

Something similar can happen in banking. One could call this the ‘paradox of prudence’: When a bank falls on hard times, the prudent thing to do is reduce leverage, raise credit standards and put less capital at risk. When a single bank does this, it may result in a marginal decrease in economic activity. However, when a negative market event occurs that may affect the entire financial system, uncertainty is more widespread as investors try to determine the degree to which banks will retrench and increase their prudence. If bank retrenchment is pervasive, uncertainty about potential negative effects on economic growth may build on and sustain market volatility triggered by the initial event.

In the pre-reform world, with high leverage, low capital quality and little transparency, not only is the degree of uncertainty high, but it can take a considerable amount of time for a clear picture to emerge as to how banks are actually responding. In such a scenario, volatility in capital markets may persist until the picture is more clear.

However, in the current post-crisis regulation regime, a high degree of prudence at financial institutions is required at all times. In this new environment, banks don’t need to become "more prudent" in response to negative developments. Furthermore, increased transparency allows for a clearer picture of how banks are responding. One could argue this results in less uncertainty and less volatility.

Decrease in Competitive Forces
Increasing consolidation of existing businesses and low rates of new business formation during much of the current economic expansion may have resulted in less competition for existing businesses. Mergers of competing firms in industries like airlines, hotels, and telecommunications can reduce the impact of competitive dynamics in these now highly consolidated industries, potentially lowering price volatility among companies. When large companies integrate more focused operators, such as a large online retailer acquiring a grocery chain or a large pharmaceutical company making a biotech acquisition, the resulting consolidation can have a similar impact.

At the same time as these consolidations have occurred, the decline in new business formation post-financial crisis may have also resulted in less competitive disruption from new entrants in many industries. In fact, the annual number of startups was close to a 40-year low as recently as 2014.1 Startup activity increased sharply in 2015, but it is too early to know if that trend will persist or if recently formed businesses will become a competitive threat to incumbent companies, some of which are now very large.

Low Rates of Corporate Investment
The overall rate of corporate investment during the post-crisis economic recovery and expansion has been among the lowest of all expansions since 1961.2 The investment rates for software and information processing equipment have been lower than during any other expansion. Investments in research and development and intellectual property have also been growing more slowly relative to other expansions.

Low investment for future growth combined with profit margins persistently at the high end of their historical range suggest that many companies may be prioritizing current profitability over future growth. Without large changes in revenue and profitability that can result as growth-oriented spending succeeds or fails, corporate cash flows may be more stable – thus possibly reducing uncertainty and price volatility.

Are markets too quiet?
A combination of these three forces may help explain the low volatility environment that has persisted in recent years. However, even if the actual drivers of low volatility are accurately identified, it would not be prudent to conclude that market volatility is a thing of the past. Although these drivers may be entrenched and the circumstances that brought them about are unlikely to change quickly, these forces may be overwhelmed at any time by events that can rapidly increase volatility.

Volatility is a cyclical phenomenon and the current low phase of the cycle will eventually come to an end. A return to persistently elevated volatility may happen gradually as the forces keeping volatility low slowly erode, or it may happen suddenly due to an external shock to the system.

Investors with long-term investment objectives may benefit from remaining diversified while considering different approaches to risk management. When the market does transition from a low volatility regime to a period of elevated volatility, incorporating investments with reduced interest rate sensitivity and reliable equity market downside protection could be an important consideration.

 


1 414,400 firms were born in 2015, according the U.S. Census Bureau. See: "Startup Firms Created Over 2 Million Jobs in 2015." 20 Sep. 2017. census.gov.

2 "What Accounts for the Slow Growth of the Economy After the Recession?" Congressional Budget Office. 14 Nov. 2012. cbo.gov.

All investing involves risk, including the risk of loss.

Volatility management techniques may result in periods of loss and underperformance, may limit the Fund’s ability to participate in rising markets and may increase transaction costs.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

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