Volatility has been low across all investment markets as investors search for direction, but has started to pick up over the last couple of weeks. Earnings and economic growth expectations have driven markets higher this calendar year, but the last few months have seen markets plateau due to political risks and worries around the end of easy central bank policy.
Globally, equity markets have been fairly flat over the past month, while fixed income yields have drifted higher amid hawkish tones from central banks. The expectations of rising yields has investors grappling with the possible effects on valuations of growth stocks and ‘bond-proxy’ stocks, both of which have been major beneficiaries of the low interest, easy monetary policy environment since the Global Financial Crisis.
Like equities, commodities have been range bound, with a rally over the last month erasing the previous month’s losses.
The Australian Dollar has strengthened significantly this year, up 10% to approximately 79 US cents due to the strength of commodities and weakness in the US Dollar. US Dollar weakness has been primarily driven by weak wage growth and the Trump administration’s inability to make any significant progress in legislative changes.
Australian economic data has been positive this month, with manufacturing activity showing broad-based strength, and retail sales jumping 0.6% in May, three times the 0.2% that economists were expecting. This was somewhat offset by continued indications of a weakening housing market, with building approvals down 5.6% in May, and house price growth moderating to 2.2% for the first quarter of 2017.
Following weak economic data from the US in recent months, this month’s figures featured a number of positive surprises across the board, indicating that growth continues to be robust. US first quarter GDP rose 1.4%, manufacturing and services surveys both came in better than expected, consumer sentiment is hitting new highs, and the labour market showed much stronger growth than expected; however, wage growth continues to disappoint and remains the missing ingredient. If wage growth does pick up as expected, this could spur another rally in equity markets.
Meanwhile, the European economy continues to perform strongly which has triggered some talk of the European Central Bank (ECB) ending its quantitative easing program and hiking rates. The Chinese economy is also displaying resilience and continued growth despite the government’s shift to focus on deleveraging earlier this year.
The primary areas to keep a watch on in the near future are wages and consumer spending both locally and abroad as this continues to be the missing final piece of the puzzle. Bond yields are another key area to watch as the US looks to raise rates one more time in 2017 but the primary focus will be on the unwinding of the US Federal Reserve’s balance sheet.
Volatility where art thou?
In recent times, volatility across the various investment classes have evaporated and the volatility indices are at historic lows. This is not the sort of market behaviour that one would expect to see when asset prices seem high across the board, and the economies across the world are facing a variety of major political risks from Brexit to North Korea and President Trump to Middle East tensions.
Historically, volatility expectations in investment markets and major political risks that have a perceived threat on the economy were closely correlated. Over the past two years, the relationship has broken down as soaring global economic policy uncertainty was met with falling volatility expectations, as shown in the chart below.
Analysts have theorised a variety of reasons for this decoupling. The common ones are as follows:
The shift to passive investing
Over the past few years, there has been a huge influx of money moving into passive index funds across all the asset classes. This has led analysts to theorise that the passive approach could lead to calmer periods in the investment markets, but could also increase the risk of any sell-off being exacerbated by indiscriminate selling.
Quantitative investors and algorithmic traders
Increasing computing ability and faster connection speeds have led to a rise in quantitative investors and algorithmic traders in recent years. Given the swift response time of these computer traders, the theory is that markets have become more efficient resulting in lower volatility. Like passive investing, there are some analysts that worry the rise of these machine traders could exacerbate sell-offs.
More efficient markets
Another theory based on technological advancement, markets are seen to be significantly more efficient as the internet allows for faster and more widespread information sharing, while faster computing allows faster analysis of this information. Technological advancement has also resulted in lower investment costs such as price and administration, removing another source of market friction.
Quantitative easing (QE)
Central banks have flooded investment markets with trillions of dollars since the Global Financial Crisis. In addition, these central banks have injected this cash primarily via the purchasing of defensive assets such as bonds. This has left investors with mounds of cash with less options of where to put it. QE has also led to an extremely low interest rate environment. This has pushed investors into riskier assets in search for satisfactory returns. A prime example of this is the rally of the so-called ‘bond proxies’, investments that have yields perceived to be sustainable. This reduces volatility as any dip in risky assets leads to return-hungry investors quickly snapping these assets up.
However, central banks have started to move from QE to tightening. This means that a key reason for the current low volatility environment is being removed, possibly resulting in the reappearance of volatility.
Easing out of quantitative easing
The US Federal Reserve (Fed) has already raised rates twice in 2017, with more to follow, and has also disclosed that it will start to reduce its balance sheet by letting investments of US$10 billion per month roll over without reinvesting these funds. This is set to increase to US$50 billion per month gradually. The effect of this is similar to taking cash out of the US financial system and serves to restrict monetary conditions.
The Bank of England (BoE) and European Central Bank (ECB) have also indicated potential tightening moves, although this is expected to be some while away and far less clear in the BoE’s case due to Brexit. The ECB is currently still buying up bonds on a monthly basis but has already tapered from 80 billion euros per month to 60 billion euros per month, and is expected to taper further with an eye to ending its QE program sooner rather than later, before eventually starting to reduce its balance sheets in a similar fashion to the Fed.
As shown in the chart below, the combined balance sheets of the ECB, Fed and Bank of Japan is a significant amount of close to US$14 trillion, and has been a factor in both the bond and equity market rallies.
The key question here is not how will this affect the financial markets but rather to what extent? The reduction of these central bank balance sheets is akin to taking money out of the financial markets, which is expected to have a similar effect as hiking interest rates. The exit is likely to be orderly and will be broadcasted by central banks well in advance in the effort to minimise the risk of another ‘taper tantrum’. However, the central banks’ easing out of quantitative easing will likely result in volatility coming back into the market as a result of lower liquidity, and a re-valuation of risky assets.
The unwinding of QE could mean a return to the old normal, with equity markets becoming more volatile, and risk-free assets hopefully providing some real return (return above inflation). A more volatile environment means investors should expect a bumpy ride but it will also throw up investment opportunities for those who are ready to take them.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Bentleys Wealth Advisors we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
If this article has raised questions regarding your personal situation, please contact Bentleys Wealth Advisors directly or on 02 9220 0700.
This information is general in nature and is provided by Bentleys Wealth Advisors. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.