Home / Volatility is on holiday, not retired

Students of ancient history will remember leafing through text books and coming across the term ‘Pax Romana’, Latin for the Roman peace referring to the calm experienced across the Roman Empire in the 1^st and 2^nd centuries AD. Markets and economies now appear to be living through the Pax Central Banker age.

The US Federal Reserve (the Fed) in concert with partners like the European Central Bank (ECB) deserve kudos for successfully fighting off the threat of a 1930s-like economic collapse through a combination of zero official interest rates and flooding markets with credit through quantitative easing (QE).

Nevertheless, no success comes without a cost. For active investors, the biggest unintended con­sequence of the unprecedented central bank policies is dramatically suppressed financial market volatility. [1] Market volatility today in all asset classes – equities, bonds and currencies – has dropped to either all-time lows or is close to record lows (Figures 1 and 2).

Figure 1:

Figure 2:

Rather than being welcome, however, prolonged low volatility hurts investors and markets.

Financial markets need a certain level of volatility to properly price assets. Some volatility is needed to make markets work and deter excessive risk taking.

End of market voting

Low volatility has not come about because markets have decided this, but because it has been imposed by central banks. The beauty of capital markets is that they are voting systems, people vote every day with their funds. Now voting is finished.

The hand of policy makers and officials is being felt in other ways too.

One stems from regulators’ efforts to make the financial system safer. Reforms since the financial crisis have increased the cost to banks of providing dealing services and reduced trading on their own books. In currency markets, regulatory probes into the alleged manipulation of benchmarks have contributed to lower trading volumes.

This has resulted in the brokerage and investment banking industries finding themselves under pressure from declining trans­action volumes and deal flows. While the broader community is unlikely to lose any sleep over lower earnings from investment banks’ trading activities, there are downsides that need to be borne in mind. 

Anxieties can spread fast at times when there is little trading. That’s what happened last year in the US when owners of municipal bonds found few buyers during a bout of selling. Nerves became jangled and prices plunged.  

A few big sales can push prices down dramatically when there are fewer shocker absorbers in the investment ecosystem to manage potentially large disruptions.

Prepare for change

While the foregoing may be read as a lament over the juncture that markets have reached, active investors can begin to take heart because change is on its way.

Volatility has been sedated. It’s not dead.   

In the UK BOE Governor Mark Carney has noted that, ‘Growth has been much stronger and unemployment has fallen much faster than either we or anyone else expected….’ he warned that the ‘first rate hike….could happen sooner than markets currently expected.’ [2]

Across the Atlantic, US inflation and employment growth is gathering speed. The May Consumer Price Index showed that annualised US inflation lifted-off beyond 2 per cent, the highest reading since October 2012. This was the third month in a row where inflation readings exceeded market expectations.

The upshot is that portfolios configured for low volatility by being long equity and exhibiting high interest rate risk will be particularly vulnerable. This realisation is the impetus for the development of alternative investment strategies.

While less liquid strategies can help to smooth returns thanks to less frequent valuations and regular cash flows, liquid strategies are designed to navigate policy and market sentiment shifts. Said differently, liquid strategies can be a source of potentially higher returns as volatility awakes.

Fixed interest markets provide a means of acting on macroeconomic insights and taking advantage of increased market volatility.

Going deeper; government bond strategies can be structured to be long or short or to avoid directionality altogether. Such non-directional strategies include country spread and curve trades. Country spread trades provide opportunities as economic outlooks and monetary policy diverge as they are doing now. For instance, the ECB and Fed are moving in different directions. While the former has stepped up the fight against disconcertingly low inflation, Fed policy is gently normalising.

Investing in corporate bonds (credit) can carry significant interest rate risk. However, credit risk, stripped of interest rate risk, reduces the correlation to government interest rates and reveals exploitable opportunities to active managers. To remove ‘credit beta bias’, corporate credits must be disassembled and sources of risk and return individually and actively managed. This will provide opportunities to take advantage of more idiosyncratic risks across countries, industries and issuers.

The skills and mindset required to produce absolute returns are different from those required to outperform a benchmark. As strategies become more sophisticated and as managers are allowed more flexibility than before, the focus should be on identifying managers utilising diversified sources of alpha, backed by strong resources research and a steel-like risk framework.

It would be little good outperforming rising markets to then seriously underperform weaker ones. Having the skill to manage through drawdowns is perhaps even more important than doing well in a rising market.

In this context, overdependence on Value at Risk (VaR) as a risk-measurement reference deserves some discussion. VaR-based models bound by data from an era of low volatility are too narrowly cast and will be inadequate as volatility tracks higher, in our view.

History can be a poor guide to the future, especially if it turns out to be unexpectedly different from the recent past.  On the other hand, incorporating macro scenarios that envisage the unusual can be especially valuable in quick moving and changing markets.

After a lengthy holiday, volatility is coming back to do its work. Active investors should welcome this.