by Purpose Investments Research, Purpose Investments
After brief spikes in April and early July, equity market volatility has retreated once again to subdued levels. Given the turmoil of the last few months – recent terror attacks in the U.K., the French presidential elections, events at the White House, and elevated hostility with North Korea, to name a few – one would reasonably expect volatility to increase. So why hasn’t it?
CBOE VOLATILITY (VIX) INDEX – MONTHLY
Source: Bloomberg L.P., Purpose Investments, as at July 27, 2017. Data points are monthly (month-end), except for final data point, which is the closing level on July 27, 2017.
There is certainly an element of seasonality – volatility levels generally come down in the summer. Equity markets have also learned to discount macro risks such as elections, referendums, and terrorism, as any time investors have sold in the face of these events, it’s been the wrong thing to do. Ultimately, the only things equity markets appear concerned about now are slowdowns in economic growth and the potential for recessions.
With a continuation of relatively synchronous developed-market reflation, slowdowns or recessions do not seem likely in the near term. Economic expansion continues (albeit at different rates) in the U.S., Europe and Asia. Meanwhile, leading indicators are improving, labour markets are tightening, and wages are starting to increase. The problem is, advancing global economic conditions have also prompted central banks to signal the end of quantitative easing (QE) measures, and even start increasing interest rates. The U.S. Federal Reserve has gone one step further, indicating it will start shrinking its $4.5 trillion balance sheet this year.
Why Could this Be a Problem?
Dampening of volatility is widely considered to be one of the consequences of QE. The scope of bond-buying and ultra-low rates have driven investors into riskier assets in the search for yield, and markets have come to expect central banks will step in with more QE at the first sign of a problem. However, central banks have now largely reversed course. This is worrisome, as many investors may find they’re ill-prepared for a macro event that returns volatility to long-term average levels. The last time we saw this level of complacency in the markets was in 2007, and we all know how that played out.
In addition, hawkish central bankers have prompted a significant selloff in bonds, and will likely continue to pressure fixed-income holdings. There will be fewer places to hide.
How Long Can these Levels Persist?
Volatility levels can stay low for extended periods of time. However, the ultra-low levels we’ve seen lately have tended to last only a few weeks before a random headline or event prompts a regrouping. That being said, we believe any near-term correction is likely to be relatively shallow in the summer months, despite recent tightening of monetary policy.
A nuance investors should be aware of, however, is that despite a fairly stable broad market (S&P 500 Index), we’ve actually seen a lot of dispersion under the covers.
Factors that have performed relatively well (e.g., momentum, quality) appear to have paused, likely due to profit-taking, while the value trend re-emerged in June. Defensive and cyclical sectors have also seen significant rotations in the year to date.
Weekly sector movements, S&P 500 Index
Source: Bloomberg L.P., Purpose Investments, as at July 21, 2017.
Where Are the Best Places to Invest in this Type of Market?
Equities tend to keep rising when there is nothing hampering the top side.
- If volatility levels remain low, we think U.S. equities could remain high. In addition, while value has lagged year to date, we believe there is still a significant opportunity for outperformance going in to the second half of the year. Cyclical value stocks such as financials and industrials are particularly likely to benefit.
- The shift into international equity markets also looks set to continue, as investors start to look for value outside of the U.S. Economically, Europe continues to recover, and geopolitical worries have subsided substantially. E.U.-friendly Emmanuel Macron won both the presidency and a parliamentary majority in France, and Chancellor Angela Merkel could win her fourth term in September’s German elections. In addition, a hard Brexit appears unlikely after a U.K. snap election left PM Theresa may with a minority government.
- Equities can continue to go up as rates are still low, but at some point rising rates will hamper a larger equity rally, especially if inflation remains soft. Stocks that tend to be more sensitive to interest-rate movements, such as utilities, telecommunication services and real estate, will likely lag. However, some sectors – such as financials and industrials – can outperform.
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