It might be a little soon to be feeling nostalgic for 2017 but after the last couple of months many of us could be forgiven for casting a longing glance back a year when equity markets posted unbroken monthly gains and volatility was conspicuous only by its very absence.
Now that the first quarter of the year is behind us, this might be a good time to look back at recent volatility and ask what was behind it and what can we expect in future – a volatility post-mortem if you like, with the caveat that the patient is alive and well.
After a record start for equity markets in January, major global equity markets have since sold off aggressively. New records were set: the volatility index, known as the Vix increased more on 5 February than on any other single day in its history in both point and percentage terms.
Despite this, it is important to bear in mind that when looked at in a historical perspective, neither the equity index losses nor the actual levels of volatility that occurred were particularly unusual. They only appear so when set against the extreme calm of the previous 15 or so months.
Reasons for volatility
What was surprising was the lack of any apparent fundamental reason for the sell-off. While many point to the February US non-farm payrolls data that appeared to ratchet up concerns about higher inflation and interest rates, subsequent events do not bear this out. If Federal Reserve policy tightening was the culprit, then it would have been correct to expect so-called ‘bond proxies’ (high dividend and low volatility stocks that offer the safe and predictable income qualities of bonds) to underperform other equities. But this did not happen; the sell-off was highly correlated across regions, sectors and styles.
This interest rates/inflation theory was dealt another blow when despite US inflation data showing a far sharper increase than expected and 10-year US Treasury yields touching 2.9 per cent for the first time in four years, equity markets went up.
All this leads us to deduce that the sell-off was largely technically driven. However, this does not make it irrelevant for longer-term investment considerations.
In recent weeks, we have seen sequential waves of systematic selling in equity markets by market participants using algorithms. While most of these systematic flows have worked their way through the system for now, recent events highlight their potential to instigate and sustain destabilising feedback loops in both volatility and underlying asset markets.
Technical crashes
In our view, financial markets are increasingly susceptible to these ‘technical’ crashes as the use of algorithms and passive rules-based approaches continues to grow. They can have a significant impact on both investment performance and investor sentiment by greatly amplifying corrections that have their roots in more fundamental concerns.
Looking ahead, although the sell-off was technical, it may well mark the start of a shift in investor sentiment. Many investors still deem a continuation of moderate growth, low inflation and gradual interest rate rises as the most likely outcome, but a scenario in which inflation expectations and rising rates are negative for equities, corporate bonds and government bonds has probably gained in credibility.
As these two views compete then the base level of volatility will increase as investors become more sensitive to new information, given it is very hard to construct portfolios that can perform well in both scenarios.
Indeed, our expectation is that we are leaving extremely low volatility behind and are likely to see higher volatility in equities as well as other asset classes, regardless of market direction. But before investors make for the hills, it is important they remember that this is merely a return to more normal levels of volatility and that 2017 was the real outlier.
Arne Staal is head of multi-asset quantitative strategies of Aberdeen Standard Investments
