We have a well-known aversion to forecasts. Most of the time, they are either wrong or already discounted in the price of financial assets. All too often investors become over-dependent on them and ignore the evidence which financial markets generate on a daily basis. One of the behaviour patterns that goes along with this syndrome is an inconsistent attitude to time and risk. We all know about “not blowing it in the fourth quarter” – reducing the risk limits if the portfolio has outperformed for first three quarters. However there is an equal and opposite tendency to be too tolerant of risk in the first quarter. So while everyone else is talking about year-end targets for earnings, and Treasury yields and oil prices, we will devote the rest of this note to volatility trends.

For most of the last two years volatility in the US and other developed equity markets was in a downward trend. There are several possible explanations for this, but in the last resort they are all irrelevant. What matters is the behaviour and the fact that it has now changed. In the US the nadir came in late June. Since then volatility has risen to a two-year high. It is still below its long-run average, but it has more than doubled since the lows. The story is similar for Japan and Western Europe, though the percentage increase is higher in the UK and lower in the Eurozone and Japan. This matters because rising volatility is always one of the main factors which will lead us to reduce our recommended equity exposure.

Despite the commentary about emerging markets, the increase in equity volatility across the region is not that great. There are examples in Latin America and EMEA where the spike has been large. But in Asia the increase since the low is less than 50% and the current level is well below the two-year high. We regard this as convincing evidence that Asian and Latin American markets have begun to decouple. The volatility of EM bonds is similarly subdued and also well below its two-year high.

In US debt markets, behaviour is mixed. A clear rising trend in US Treasuries should be compared with no significant change in the volatility of investment grade credit and a sudden jump (but also a recent peak) in high yield. What is interesting here is the idea that the riskiness of corporate credit relative to US government bonds may actually fall over the coming quarter (subject always to the impact of duration). There are no prizes for guessing that the volatility of all energy-related commodities has shot up, but it is actually trending lower in commodities such as wheat and copper. However the big winner in the volatility race is US REITS where volatility has fallen sharply in recent months and is now approaching a two-year low.

Our conclusions are as follows. (1) There is a widespread consensus that that US equities and US Treasuries are the two safest asset classes this year. Yet both of them exhibit a clear trend of rising – not falling – volatility. They are more risky now than they were in the summer of 2014, yet investor attitudes do not seem to have changed. (2) There may be opportunities in asset classes where volatility is falling, but the improvement is not recognised by the commentariat – specifically Asian equities, US REITS and US corporate credit.

Leave a Reply

Full Blog Archive:

Other Recent Posts