Written by: David Lebovitz
Volatility went missing earlier this year, leading investors to question not only what has driven this decline, but whether these very low levels of volatility are an indication that markets are due for some turbulence. We believe that today's low levels of volatility can be explained by a number of different macro trends, and is not necessarily a signal that correction is imminent.
First, years of easy monetary policy has led to a decline in macroeconomic volatility - in other words, economic indicators have not been as noisy. This, along with policymakers who have kept one eye on financial stability, has pushed equity market volatility lower. Second, realized volatility - for which we have a far longer time series than implied volatility as measured by the VIX - has fallen to levels only seen three times over the past sixty years: the 1960s, the 1990s and the early 2000s. Third, correlations between individual equities have declined, as stocks trade more according to their fundamentals, rather than broad risk-on/risk-off macro developments. And finally, the proliferation of exchange traded products has made it very easy for investors to go short volatility, boosting the amount of income their investment strategies generate while pushing implied volatility to artificially low levels.
So what has happened the past three times that volatility has been this low? While the cyclicality of the equity market means that corrections are inevitable, it has historically taken a couple of years after realized volatility is as low as it is today for a sharp correction to occur. As a result, we understand that these very low levels of volatility may be making some investors nervous, this nervousness may be unwarranted.
Investors are right to be concerned with valuations, as over the long-run, there is a significant relationship between valuation and forward returns. Page 6 of the Guide to the Markets looks at this relationship over the past 25 years – during this time period, valuation has explained about 10% of the variation in 1-year returns, but a hefty 42% of the total variation in five year returns. This serves as a reminder that valuations are not necessarily a good predictor of where the market is headed in the short-run, but over longer periods of time, valuation matters.
Healthy earnings growth suggests that there is still upside in U.S. equities, but this area of the global equity market is most expensive relative to its long-term average. However, history has shown us that expensive stock markets can get more expensive before they get cheaper, as multiples tend to expand in the final stages of a bull market. Thus, while multiple expansion could provide a modest tailwind for U.S. equity returns going forward, earnings should be the main driver. As such we are looking for mid-to-high single digit returns from U.S. equities as long as earnings growth remains healthy.
Outside of the U.S. the opportunity set is more attractive, and although very few markets look cheap on their own, relative valuations tell a different story. As shown in the chart below, European, Emerging Markets and Japanese equities all look cheap relative to their counterparts in the U.S. – in other words, the starting point is more attractive. This dynamic, coupled with the emergence of healthier economic and earnings growth abroad over the past twelve months, suggests that long-term investors may want to increase their focus on markets outside of the U.S.
Federal Reserves (Fed) policy will be a key determinant of risk asset performance going forward. We continue to expect a third rate hike in December of this year, followed by two hikes in 2018. The futures market is currently assigning an 83.6% probability that the Fed hikes rates before the end of this year, but traders only expect a half of a rate hike in 2018. This market view is likely too benign, and will need to adjust.
Meanwhile, balance sheet reduction seems to be on autopilot. The Fed is currently allowing $10 billion of assets to mature each month – $6bn in Treasuries and $4bn in mortgage-backed securities – and this cap is set to rise every three months until a terminal run-off rate of $50 billion per month is attained. Balance sheet reduction should have a minimal impact on risk assets; if anything, an unwinding of the balance sheet should put a bit of upward pressure on long-term interest rates.
So what should investors watch for? One potential threat to risk assets is that investor expectations are forced to re-price next year if inflation accelerates or the FOMC finds itself with a more hawkish policymaker at the helm. This re-pricing could result in a temporary bout of dollar strength and volatility across financial markets, but it is unlikely that it would bring this current bull market to an end. The larger risk has to do with relative valuations and risk adjusted returns – in other words, at what point does the relative cheapness of equities no longer compensate for their higher volatility? With the 10-year U.S. Treasury currently yielding 2.4% it seems safe to say we are not there quite yet, but with a lower terminal rate this cycle, this inflection point may be lower than it has been historically.
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