Low volatility may be a sign that equities can continue to rise rather than suggesting that a market correction is imminent, according to UBS Asset Management’s Erin Browne and Dan Heron.
As a measure of near-term volatility, the CBOE Volatility index, or VIX, has broadly trended lower this year as the equity bull market has continued, as the below chart shows.
Performance of VIX over 1yr
Source: CBOE
The soc-called 'fear index' has been trading at or near 10 for much of the past year. According to Alex Scott, deputy chief investment officer at wealth manager 7IM, so far in 2017 there have only been eight days where the S&P 500 had moved by more than 1 per cent in either direction, which he said was “extremely unusual”.
He added: “To put that into perspective, in the average year since 1950 there has been 49 days where the S&P 500 has moved more than 1 per cent.
“This gives a good illustration of how unusual current conditions are. There is time yet for volatility to return, but if it does not, 2017 will stand – on this measure – as the least volatile year in over 50 years.”
With volatility low, some have become increasingly concerned about a market correction, particularly with equity valuations looking stretched.
However, low volatility may not necessarily suggest that valuations are due to fall and can in fact signal the opposite, according to UBS Asset Management’s head of asset allocation Erin Browne and senior strategist Dan Heron.
“Much of the commentary regarding investor complacency takes aim at the very low levels of the widely-watched VIX index and investors’ perception of the VIX as a strong contrarian indicator,” the pair noted.
Yet, analysis by UBS found that low levels of volatility have not prevented equity market growth.
“In fact, since bull markets are associated with low levels of volatility it should be no surprise that average global equity returns have been meaningfully higher in low volatility regimes than high volatility regimes.”
When looking at VIX values by decile and subsequent 12-month equity returns, the pair noted the largest drawdowns have tended to occur when levels of implied volatility have started to move higher.
Source: UBS Asset Management
They said: “In fact, of the 43 annual drawdowns in the MSCI World in excess of 10 per cent since 1990 based on monthly data, not one has occurred when the starting value of the VIX was below 15.”
Browne and Heron said similar results had occurred with the MOVE index – Merrill Lynch Option Volatility Estimate index – the bond counterpart to the VIX index.
“All historical 12-month global equity drawdowns have occurred when the MOVE index is higher than current levels,” the pair reported.
“However, it is worth noting that some of those drawdowns have occurred when the MOVE index was only marginally higher than current levels.”
With this in mind, the pair said lower volatility and higher returns from the equity market could continue for some time for several reasons.
Central banks have played a key role. Quantitative easing (QE) programmes and the low rate environment have stabilised markets after the global financial crisis of 2008 and encouraged investors to seek out higher returns in riskier segments of the market.
“We believe that there are both structural and cyclical forces at work in the current low volatility regime and that the cyclical drivers will abate only slowly over an extended period,” the pair said.
“In particular, loose monetary policy and forward communication from major central banks have helped to reduce economic volatility.
Browne and Heron note that the QE reversal process in the US has been clearly communicated and do not expect further withdrawal of stimulus to contribute to higher volatility in 2018.
The duration of the rally has also been a subject of some speculation over whether a major drawdown – characterised as a three-month fall of more than 5 per cent – is imminent, given its longevity. The UBS experts noted, however, that “well over another year” could pass without a drawdown before surpassing the previous longest period.
Finally, geopolitical risk has become less of a factor for the VIX, despite several geopolitical challenges facing markets recently. Rather than suggesting indifference though, Browne and Heron believe it has become more difficult for investors to accurately price such events.
“On the whole, investors have either largely ignored geopolitical risks or they have taken any initial risk aversion in their stride,” they noted. “We believe this simply reflects the difficulty in accurately assessing political risk and investors’ strongly held belief since the financial crisis that, in the main, these events will not significantly impact economic growth or profitability while monetary policy remains so accommodative.”
Source: UBS Asset Management
Ultimately, Browne and Heron note that current conditions can support the ongoing rise in equity markets even if they appear stretched.
“Equity valuations appear full on a P/E [price/earnings] basis, particularly in the US. However, … low rates and low economic volatility are likely to continue to support high equity multiples,” they said. “Meanwhile, equity valuations in aggregate remain compelling versus bonds.”
Overall, 7IM’s Scott said while it is important to observe that markets are behaving in a highly unusual manner it is equally vital to not read too much into just one metric.
“After all, today’s record-low levels of volatility may be unusual, but conditions like this can persist long enough to be very painful for any investor who predicts a change of environment and positions for it much too early,” he said.
“Observing today’s dead calm in markets gives us no particular insight on when the financial weather will change, but reminding ourselves how unusual current conditions are helps us to be prepared for the inevitable when it does come.”