Once upon a time, a coup in an emerging market or the threat of a renewal of the cold war would have had investors worried about possible “contagion”. What is different now?
Central banks at work
The simple answer is that this is a byproduct of central bank policies. Financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose – meaning credit is both available and cheap – market volatility tends to be lower.
This relationship is evident when you compare equity market volatility with a proxy for credit market conditions, such as high yield spreads. In the past, the correlation between high yield spreads and equity market volatility has been roughly 80 per cent.
Today, short-term interest rates are still stuck at zero, real short-term rates are negative and companies are flush with cash. In other words, credit conditions are about as easy as they get, a fact reflected in tight high yield spreads, currently at a seven-year low of about 350 basis points. With credit conditions this easy, you would expect a low volatility regime.
Of course, other factors have been at work as well. Since investors have been comforted in recent years by the warm blanket of central bank accommodation, they are essentially conditioned to “buy the dip”.
As a result, increases in volatility around a new geopolitical event have, up until now, been shortlived. Stocks have also been supported by a steady stream of mergers and acquisitions.
That said, there is a big difference between where volatility should be and where it is. Even after adjusting for unusually tight credit spreads, volatility should be in the mid-to-high teens, not scraping close to single-digits.
Recent levels of volatility have been in the bottom 1 per cent of volatility levels going back to 1990. In other words, it looks too low even after accounting for a benign credit environment. This is particularly so given that up until last week investors were ignoring rising geopolitical risk.
Indeed, the recent escalation of violence in Iraq and Ukraine has raised the stakes. Turmoil in both regions has the potential to cause a spike in oil prices, which would be a real headwind for the global economy at a time when economic growth is fragile.
Rate rise calculations
How the Federal Reserve acts in coming months could also have an impact on market volatility. If we see continued economic improvement – and June’s strong employment numbers seemed to be another sign that the slowdown earlier this year was a weather-induced aberration – the Fed may begin raising short-term interest rates.
To the extent a rate rise occurs earlier than investors expect, this could affect volatility. A marginal tightening in monetary policy means a less accommodative credit regime, which in the past has generally been associated with an uptick in volatility.
Still, all else being equal, stocks can continue to climb this year. Stocks are fully valued after a strong rally, but the lack of attractive alternatives (bonds are expensive and cash pays zero), and a slow, but steady, recovery, can support further modest gains. That said, further gains are likely to come with more volatility.
Complacency is still the biggest risk, with little bad news priced into the markets. Investors might want to consider taking steps that can help insulate them against an increase of volatility if – or when – it spikes up again.
As every student of US film clichés knows, when the hero in the movie says “It’s quiet, too quiet”, bad things are about to happen. It is impossible to predict when the next bad thing will happen, but it is unlikely our good fortune can last. Investors should consider preparing now.