Since Q1 2016, volatility across assets, and in particular for equities, has declined and stayed remarkably low YTD. As a result, investors often ask how long the current 'boring' markets can continue, and what the risks and asset allocation implications are.
Long periods of low volatility are not as unusual as they may seem.
Low volatility tends to linger – if volatility is very low, it often stays low in the subsequent 12 months. We identify 15 low vol periods for the S&P 500 since 1928 and, on average, they lasted 18 months. The macro backdrop during those periods was very supportive, resembling a 'Goldilocks' scenario of improving growth with anchored rates and inflation, similar to now.
Timing the end of such a low volatility period is unsurprisingly difficult.
Historically, many volatility spikes were hard to predict as they often occur after unpredictable events, so-called 'unknown unknowns'. However, volatility regimes are closely linked to the business cycle. Low unemployment rates tend to anchor equity and rates volatility, whereas rising unemployment signals recession risk and a higher vol regime. The Great Moderation coupled with central bank buffering have likely helped reduce volatility structurally, in particular for bonds. But uncertainty on central bank policies could drive higher volatility going forward.
For equities we see little sign of a structural shift downwards in volatility, in part as vol of vol has increased. Low vol periods are usually 'risk on' and carry-friendly, with both equity and credit valuations increasing. However, a prolonged low vol period can also result in excessive risk taking. And it can mask correlation risk in multi-asset portfolios. As implied volatility has reached decade lows across assets, we think it is time for investors to consider all options. We like cash extraction through calls in equities and put spreads to hedge tail risk.