Amid a backdrop of uncertainty, with slowing global growth, trade disputes and a sharp change in narratives from central banks, various measures of market volatility are surprisingly muted.
The VIX index, which measures the market’s expectation of volatility implied by S&P 500 index options, is at a multi-year low. The MOVE index, the bond market’s equivalent of the VIX, follows the same trend. Both measures appear calm, relative to the Economic Policy Uncertainty index, which measures deviations in economic forecasts and the number of mentions of the word “uncertainty” in articles.
One explanation for this mismatch could be attributed to the drying up of market liquidity.
This could be the effect of quantitative easing on markets. QE can improve market liquidity because the respective central bank buys government bonds, providing liquidity. This reduces yields and ultimately causes a crowding-out effect; investors step up the risk curve buying riskier assets – liquidity bleeds across the financial system. However, QE can work against liquidity. Buying too many government bonds limits the amount in circulation: liquid markets rely on a healthy a balance of buyers and sellers. For example, the Bank of Japan owns more than 40 per cent of the Japanese government bond market and in May 2018, illiquidity stopped JGB trading for two days.
Another proxy for market liquidity is the ‘E-Mini’, which captures the liquidity of the S&P 500, representing the range of buyers and sellers. In December 2018, liquidity decreased to levels that were lower than during the financial crisis. This led markets to enjoy prolonged periods of calm stretches, with an increasing number of setbacks such as December 2018’s sell-off. This is demonstrated through the VVIX index, which measures the volatility of the VIX and has trended higher since 2013.
A second reason could be regulatory pressures that have had a key role to play, as investment banks have been forced to close trading desks and scale back market-making operations. Since then, high-frequency traders, who use computer algorithms to execute several orders within a fraction of a second to harvest the profits from pricing mismatches, have entered this arena. However, they only represent a small proportion of the capital previously run by large investment banks. High-frequency traders, as a key source of liquidity, quickly withdraw this capital when markets fall, which exacerbates the price moves. This may explain the bouts of volatility that we have seen during a period of seemingly sanguine markets.
Lack of volatility led to the closure of several hedge funds which profit from higher volatility in markets. Closures were not restricted to volatility-based strategies, either. Disappointing performance and high fees have been key reasons, but there is evidence to suggest that we have entered a different phase in markets where certain strategies are unable to deliver their objectives. Investors are reluctant to bet on untested strategies and new managers, with hedge fund launches falling to the lowest level since 2000, according to Hedge Fund Research. This would indicate that most hedge funds are unable to adjust to an environment of low volatility, with increased uncertainty.
Global long-only fund managers appear to be the most bearish since the global financial crisis, according to a survey by Bank of America Merrill Lynch. In aggregate, fund managers are positioned for a low-growth and low-rate environment, with higher allocations to cash, real estate investment trusts and bonds, while sacrificing equity allocations, especially in cyclically sensitive regions. In terms of sectors, fund managers have rotated towards bond-proxies like utilities and staples, and away from cyclical sectors like banks. It would appear fund managers are aligning themselves to the Economic Policy Uncertainty index, and unlike their hedge fund peers, adapting to the changing environment.
Equity markets including the S&P 500 have just touched all-time highs, while bond markets are signalling gloom amid lingering US-China trade tensions, slowing growth and looming anti-trust regulation. Often, stocks rise when investors are confident, while bond yields fall when investors are worried about a slowing economy. It can be argued that the equity market is a lagging indicator and bond markets are a leading indicator. However, considering suppressed volatility and the uncertainty index, there is no clear indicator about the direction of markets.
We can appreciate some of the explanations for the reasons, namely poor liquidity, low market participation, equity and bond markets as lagging/leading indicators. Combined with hedge fund closures and long-only managers positioning for a setback in risk assets, should investors pull out of markets completely and run the risk of losing investment returns, or should they remain invested?
We are firm believers in not calling markets and our ethos is to position portfolios to secure the required level of volatility, optimising the portfolio and diversifying any unwarranted risk. We therefore aim to maximise the diversification ratio in relation to target volatility. This methodology allows us to invest towards a long-term objective, avoiding any unnecessary risk, including the uncertainty involved in market timing.
Tanvi Kandlur is senior fund analyst at FE