Investors may be forgiven for believing that all is currently well with the world. Access to cheap credit, a result of near zero interest rates and quantitative easing, has led to large increases in asset prices. House prices in major cities such as London, Hong Kong, and Sydney have reached levels that are unaffordable for many. Stock markets across the world are at, or near, all-time highs, despite the recent Greek-driven slumps. Even recent falls in the Chinese stock market have not wiped out all of the gains for 2015.
As a result, the Chicago Board Options Exchange Implied Volatility Index (VIX), commonly referred to as the “investor fear gauge”, is close to its lows. This indicates investors see a tranquil period ahead with low levels of market volatility and risk. As a result they are more likely to invest in risky assets such as stocks.
It is not surprising that there is a strong relationship between market returns and investor fear, with higher levels of fear linked to falling stock markets. My research indicates that at least part of this fear is driven by sentiment resulting from news, so it is surprising to see that the fear gauge has not increased sharply in response to recent global events.
Headwinds building for the world economy
Even one of the risks facing the global economy would usually be a cause for concern, but several factors that are converging together will have a significant impact on financial markets, and the wealth of investors.
First, the Federal Reserve is close to raising interest rates in the US for the first time since 2006. This will start to remove one source of liquidity that has been vital to fuelling global stock markets. Second, the financial crisis in Greece is still far from resolved and may lead to further turmoil within Europe.
Third, growth in China is slowing and more than US$3 trillion of market value has been destroyed in the space of a few weeks. The Chinese government has responded by imposing controls that question their belief in the free market system.
Finally, commodity prices have fallen substantially over the past year. For instance, oil and iron ore prices have both fallen by more than 60% over the past year. The last two points should be of particular concern for Australia which relies so much on demand on China and commodity exports to drive its economy.
Effects of rising investor fear
Previous studies have shown that periods of low market volatility do not last and are often followed by sharp increases which result in significant stock market reversals. The examples of low volatility levels prior to the dot-com crash of 2001-02, and the financial crisis of 2007-09, are used to illustrate this point.
My current working paper suggests a similar pattern for “high-yield” currencies such as the Australian dollar and New Zealand dollar, with an increase in investor fear leading to swift declines in both currencies as investors reduce their risk levels. This may be helpful for an Australian economy hoping for a falling dollar to cushion the blow of decreasing commodity exports, but would likely result in higher prices for consumers.
The question is whether we are entering a new era of low volatility and investor fear, perhaps as a result of extra liquidity added to the financial system, or is the market complacent and underestimating the potential risk in global events? The answer is uncertain, but history tells us investors that claim “it’s different this time” are frequently proved wrong.
If current perceptions of a low volatility environment are incorrect, as I feel is likely, then Australian households and investors may be hit by the “double-whammy” of falling stock markets and an Australian dollar that continues to decline in the coming months.