Calm for Now

by Erik Knutzen, CIO, Multi Asset Class, Neuberger Berman

Recent low volatility reflects fundamentals, but don’t expect it to remain in place forever.

At the start of the year, among the trends we anticipated in our Solving for 2017 outlook was a potential increase in market volatility—even as we outlined a favorable 12-month view for risk assets. After prolonged monetary stimulus that had artificially smoothed the economy and markets, central banks seemed likely to ease off the gas. Taking a more dominant role would be fiscal policymaking, impacts of the changing political map and (drumroll) fundamentals at the underlying market, sector and company levels.

A Steady Stretch

Now that we are approaching midyear, it’s worth stepping back to consider what’s happened to volatility and what it reflects about the larger market environment. Contrary to our initial view, volatility as measured by the CBOE Volatility (or VIX) Index has remained very low, spending weeks below 10 (compared to a longer-term average in the high teens) and recently settling in slightly above that historically suppressed level. This, despite many catalysts that you would think would be the source of doubt and risk aversion that tend to push volatility higher: uncertainty around the new administration’s legislative agenda, controversy over alleged campaign collusion with Russia, contentious elections in Europe, repeated terrorist attacks, and tensions around North Korea’s nuclear program. The list goes on.

In spite of all that, not only has the environment been one of relatively low volatility, but it has been coupled with the advance of risk assets, which raises the question: why the disconnect? Overall, we think the answer is investors’ focus on economic fundamentals, which all things equal tend to drive the markets over the long term.

As we anticipated at year-end, the overall economic environment has been reasonably good. There’s a global upswing in growth, restrained inflation and low to modestly rising interest rates. And the monetary environment, while still accommodative in Europe and Japan, has been one in which the Fed is beginning to remove extraordinary policy support given increasing confidence that the economy can stand on its own. Any weaknesses “exposed” by this withdrawal, or the sometimes jarring events of recent months, have yet to offset the very constructive picture that investors have otherwise observed.

What Might Change

That said, volatility is part of the landscape and eventually higher levels are likely to reassert themselves. We believe that investors should be prepared while maintaining a long-term time horizon. When volatility spikes, it’s helpful to both avoid indiscriminate selling and, where possible, capitalize on turbulence by adding exposure at attractive prices. In addition, strategies like equity index put-writing can introduce reduced beta exposure while benefiting from the high cost of market “insurance,” which investors continue to pay up for despite apparently sanguine sentiment.

It’s worth noting that, while equities’ headline volatility is low, there have been pockets of turbulence—particularly in energy, metals and some currencies. There have been very strong advances by technology stocks, but energy names and master limited partnerships have struggled in recent months.

Moreover, current low volatility could be upset by a number of elements: signs of a debt crisis or weakness in China, overly aggressive central bank tightening, consumer weakness, or major moves in currencies or commodities. In short, developments that cause investors to lose confidence in GDP growth could undermine their confidence in risky assets.

So, enjoy the current calm, but be prepared for the storms to come; we won’t always have it this easy.