Financial markets: Hurrah before the storm
Low volatility risks lulling investors into false sense of security
NEW YORK, UNITED STATES: Traders cheer on the floor of the New York Stock Exchange 18 March, 1999, as the Dow Jones industrial average hit the 10,000 point mark at the closing bell. When the final transactions were tallied up after the closing bell the market finished at a record 9,997.62, up 118.21 points for the day. The market hit the 10,000 level twice during the day before dropping back. AFP PHOTO/Stan HONDA (Photo credit should read STAN HONDA/AFP/Getty Images)©AFP
After Lehman Brothers collapsed in late 2008, financial markets around the world panicked. Almost six years later, the world may feel as vulnerable to geopolitical and economic shocks but serenity has broken out.
World stock prices have surged to historic highs, with the FTSE All-World and S&P 500 setting records this week. Yet volatility appears to have disappeared. By one measure, the Vix index – known as the “Wall Street fear gauge” – is near seven-year lows.
Life would appear blissful for investors, with markets high and calm, and the upsets of the post-2007 crises over. Geopolitical shocks, such as the tensions over Ukraine, have only briefly interrupted the upward march, although volatility gauges have risen on the latest violence in Iraq.
But like sailors sensing a lull before the next storm, some industry veterans warn of possible trouble ahead in global markets. “One of the lessons that we should have learnt is that long periods of low volatility are good in real time, but breed something more pernicious – and nobody knows when they will blow up,” warns George Magnus, senior economic adviser to UBS.
Central banks led by the US Federal Reserve have averted catastrophe and are attempting to stimulate moribund economies. But Mohamed El-Erian, former chief executive of Pimco, cautions that the artificial calm risks leading to “excessive risk-taking, over-leveraging, resource misallocation, and crowded trades that end up having surprisingly limited liquidity when conditions turn”.
The lessons of economic history appear ominous: the 2007 crisis, which started in the US subprime mortgage market and led to Lehman’s collapse, was preceded by a slump in volatility. So too was the 1997 Asian financial crisis. Data reconstructed by Société Générale suggest the 1929 Wall Street crash followed similar calm.
So is low volatility creating a false sense of security, while emergency actions by central banks have hidden inherent instabilities which might again cause trouble ahead?
Low volatility has spread globally. Falls in the Vix index have been mirrored in gauges of European and Asian share price fluctuations. A similar index for global currency has fallen to the lowest since records began in 2001. Oil volatility was the lowest since 2007 – at least until the conflict in Iraq sent oil prices higher. Bond market movements have also become less intense – whether for US Treasuries or those issued by crisis-hit eurozone governments.
“Low volatility is the most important topic in markets right now,” says Salman Ahmed, global bond strategist at Lombard Odier Investment Managers. The problem is nobody agrees just how much investors and policy makers should worry. “On the one side you have those who think this is the ‘new normal’, on the other are people like me who think it cannot last. This is a very divisive subject.”
Too much volatility is clearly bad. When the Vix index hit a record high in November 2008, investors were forced out. Fund managers could not afford the losses being notched up daily. Some volatility is needed to make markets work and deter excessive risk taking.
Maybe the central bankers can keep control, but if people stop believing in them, all hell will break loose
But current low levels of volatility are not necessarily a bad sign. “Investors may be complacent, but there is much for them to be complacent about,” says Stephanie Flanders, strategist at JPMorgan Asset Management. “Low volatility is a reflection of less volatile real economies. For that reason it can be a good thing, but if extremely low volatility is sustained for a significant period, it would make you worry about all the artificial central bank support for markets.”
Even though the Vix index has fallen, fears have not waned. The index, calculated by the Chicago Board Options Exchange, is based on options which give investors the right to buy or sell an asset at a fixed price at a fixed time in the future. If economies are on sluggish growth paths, there is less risk of price-changing news, and the Vix falls. “Vix is not a fear indicator at all. It is more an ‘information flow’ measure,” says Ramin Nakisa, volatility expert at UBS. “When Ronald Reagan got into the White House, the market melted up. But it wasn’t fear, it was joy.”
What is more, market volatility has fallen as a result of regulators’ efforts to make the financial system safer, making it harder to make comparisons with previous periods of calm. 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 almost certainly also hit trading volumes.
There are other important differences with the past, argues Marc Chandler, strategist at Brown Brothers Harriman. “While efforts to deter another one may contribute to a decline in volatility, the excesses that are associated with the financial crisis, such as extreme leveraging and opaque off-balance sheet exposures do not appear present now.”
What worries others, however, is that markets have become dangerously distorted. Large-scale asset purchase “quantitative easing” programmes by central banks sought to stimulate economic growth by driving investors into riskier assets. Since early 2009, the S&P 500 has risen by 190 per cent, and the FTSE All-World index is up 150 per cent.
Just because money managers have a much harder time making profits by trading does not mean economies suffer. But markets are not functioning normally, warns Sir Michael Hintze, founder of CQS, one of Europe’s largest hedge funds. “The problem is that we’re not there [in a low volatility environment] because markets have decided this, but because central banks have told us . . . There is no room for dissenting voices. My fear is that when everyone is in the same place is when a change in sentiment causes the maximum disruption.”
Sir Michael adds: “The beauty of capital markets is that they are voting systems, people vote every day with their wallets. Now voting is finished. We’re being told what to do by central bankers – and you lose money if you don’t follow their lead.”
One sign that markets are out-of-kilter is the conflicting stories of equity and bond markets. Soaring stock prices point to stronger economic growth. But yields on US Treasuries, which move inversely to prices, have fallen this year, normally a signal of expectations of lower growth and inflation. At the same time, overall low levels of market volatility seem at odds with evident geopolitical risks – whether in the East China Sea, over Ukraine or the Middle East.
“Elevated stock levels, elevated bonds and low volatility that ostensibly conveys confidence – that trinity is fundamentally flawed. Something will give. The issue is what and when,” says Mr Magnus. “Central banks are trying to stop bad things happening in markets. By doing so, they are encouraging people to stay in when perhaps they should not.”
The prevailing calm may soon be tested – and not just by events in Iraq. Divergences in central bank policies may start to create volatility. The European Central Bank last week announced further cuts in interest rates and fresh injections of liquidity into the eurozone financial system. The Bank of Japan also remains on the offensive: Credit Suisse calculates that if it keeps buying at the current pace, it will hold nearly 40 per cent of outstanding five- to 10-year Japanese government bonds by next March.
Now central banks have created this calm environment, they are worrying about it being a sign of complacency
- Stephanie Flanders, JPMorgan Asset Management
In contrast, the UK’s fast-recovering economy led Mark Carney, Bank of England governor, to warn on Thursday that an increase in interest rates “could happen sooner than markets currently expect”. The US Federal Reserve is also “exiting” from crisis-era policy measures by gradually “tapering,” or scaling back, its monthly asset purchases.
“Now central banks have created this calm environment, they are worrying about it being a sign of complacency,” says Ms Flanders. “They want to put more volatility back into the market, so they are not one-way bets, but can’t work out how to do it without putting the recovery at risk.”
Early last year, market volatility resurfaced temporarily when the Fed first hinted at plans to “taper” quantitative easing. Yet even if the Vix and other measures of market volatility rise in the coming weeks and months, global stock and bond market rallies may not be blown off course.
“Many people sold in 2008 and have since sat on cash, which has been very expensive,” says Greg Davies, head of behavioural finance at Barclays Wealth and Investment Management. “An asteroid hitting earth or an alien invasion would be difficult for investors to ride through, but putting such ultra catastrophes aside, when volatility increases . . . the best thing to do is to sit tight.”
Investors are rarely completely rational, however. “Unfortunately, most people’s response is to try to do something about it, thinking, against the evidence, that they can out predict the market,” warns Mr Davies.
A lot also hangs on the world’s monetary policy makers. “The central bankers very much believe they can control the exit,” says Sir Michael at CQS. “But remember, their balance sheets have never been as large. They also believe that their pronouncements will be listened to forever . . . Maybe they can keep control, but if people stop believing in them, all hell will break loose.” Serenity could become a much scarcer asset.