Why is volatility so low?
Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.
Stock markets around the globe have made a strong start in the opening weeks of the New Year (see Exhibit 1 below). As of 23 January, the MSCI All-Country World index was up by 6.3% since the beginning of the year.
Exhibit 1: Global stock markets have made a strong start to the New Year
That’s an excellent start to the year and follows on the heels of positive performance for this index in every month of 2017. Indeed it has not had a down month since October 2016.
The pattern of stock markets in developed countries repeatedly reaching new highs was a feature of 2017 – the US S&P 500 index closed at fresh all-time highs on over 60 occasions last year. On account of the outstanding performance of shares in large capitalisation technology and internet companies, the Nasdaq index made over 75 new all-time high closes in 2017, breaking a record established in 1999.
In 2017, the S&P 500 returned over 19%, marking its sixth best year in the last 20. According to S&P Dow Jones Indices, 2017 was also the first calendar year (based on data going back to 1928) in which total returns (i.e. returns including dividends) for the S&P 500 were positive in every month of the year.
By late January, the Europe-wide STOXX 600 index reached its highest level since 2015, while the Xetra Dax 30 has already touched a record high (it should be remembered that the main benchmark for German stocks is a total return index – it tracks dividends and capital returns of its constituents as well as stock price movements – so structurally, it breaks new ground more frequently).
Among the factors subduing volatility are:
– Low and predictable interest rates as central banks proceed with great caution in unwinding their non-conventional monetary policies
– The strongest synchronised pick-up in global economic growth since 2010, which has raised hopes that the global economy is now out of the recovery ward where it had been recuperating since the Great Financial Crisis of 2008/09.
– Technology-related changes in financial markets such as the development of exchange-traded funds and financial instruments that enable investors to ‘sell volatility’.
The trees, as the old adage says, do not grow to the sky. But the economic environment currently favours stocks and, as we pointed out in our Investment Outlook for 2018, central banks will continue to be major buyers of financial assets well into 2018. The tide is high, but it doesn’t look like it will be going out very soon.
Under these circumstances, it’s not surprising that the idea of a market ‘melt-up’ is being evoked in some quarters. That’s to say that in the face of this unrelenting rise, investors who have not yet joined the ride will throw in the towel and climb aboard, driving the market higher and triggering further waves of capitulation.
Measuring such shifts in mass psychology is an art, not a science. We confine ourselves to the observations that there is a noticeable absence of euphoria at this juncture and the earnings season is getting off to a good start. In our view, valuations of US stocks are starting to look extended, but we are positive on the outlook for European and Japanese stocks, both on the basis of their lower valuations and the potential they offer for earnings growth that beats market expectations.
January has seen a sell-off in sovereign bond markets. As a result, the yield of the benchmark US 10-year Treasury note has risen towards 2.60%, approaching levels last seen in March 2017, while the yield of the 10-year German Bund rose above 0.50%, where it last traded in July.
Exhibit 2: Changes in sovereign (Japan, US, UK and Germany) bond yields between 2000 and 23/01/2018
The bull market in bonds is now in its thirty-sixth year. Inevitably, stronger economic growth leads investors to doubt the continuation of the low interest-rate regime.
In our view, the forces that have driven bond yields down are secular and long-term in nature (e.g. deflationary impulses from globalisation, technology and ageing populations). We believe these forces continue to hold the upper hand. We expect 10-year rates to remain range-bound at around historically low levels for most of 2018 in the absence of inflationary pressures and the glacial pace of policy accommodation removal by the main central banks.