With the MSCI World index constantly scaling new peaks, the current bull market is one of the longest in history. But that is not its only distinguishing feature. Despite the numerous risks that have surfaced since last year, volatility has remained historically low. Brexit, Donald Trump’s election victory and fears of a populist shift in the Dutch and French elections – all of which could have made markets more nervous, pushed down share prices or at least prompted greater caution – have had much less impact than expected.
Markets took a breather in April 2015, when US economic growth showed signs of flagging, and again in early 2016, a few weeks after the Fed funds rate was raised for the first time, because of concern about the Chinese stock market and the global economy. However, these economic warning shots did not cause any long-lasting nerves in the market. Far from prompting heavy losses, the corrections they triggered were just temporary blips in an otherwise unshakeable bull run.
Disregarding political risks
With the exception of sterling, which has fallen following the Brexit vote, financial assets have behaved as if they are oblivious to political developments, even though they seem likely to bring major change. Most of these political risks are now behind us, but there are still major geopolitical uncertainties in the Gulf region, Syria, Iran and North Korea. Again, however, they are having very little impact on the financial markets.
If we add in the fact that valuations have reached record levels, the situation is disconcerting to say the least. Behavioural finance theory would regard the situation as absurd. The theory states that when markets are euphoric for an extended period, some signs of anxiety should appear, particularly in the form of higher volatility. At the moment, however, leading indicators are still positive and the VIX volatility index is at its historical low.
The current market configuration of consistently subdued volatility, low interest rates and record valuations should make investors cautious. However, investors who have remained invested in the market, without worrying too much about high valuations, have fared much better than their more nervous colleagues.
Looking for the trigger
The question is whether a downturn will happen, and what will cause it. In other words, as the financial markets approach a number of highly symbolic anniversaries – i.e. the crashes of 1987, 1997 (in Asia) and 2007 – to what extent will they continue to defy common sense?
The stabilising effect of ETFs
Many wise heads have warned about the perverse effects of passive management, particularly regarding corporate governance, and its merits have been extensively compared with those of active management. Without rehashing the active/passive debate, it is worth highlighting the effects caused by the considerable increase in passive investing. The passive approach has sometimes been accused of accelerating market movements and thereby increasing volatility. However, recent research has shown the opposite: the current thinking is that the more ETFs and tracker funds there are in the market, the more the volatility of underlying assets tends to decline. Any correction automatically forces these funds to rebalance, and that may have a stabilising effect on the asset classes concerned. As a result, self-sustaining declines and snowball effects, whose psychological roots have been so effectively demonstrated by behavioural finance theory, seem to have been tempered or even eradicated by the current pre-eminence of passive management.
A second factor that could explain markets’ resilience relates to regulations in the insurance and pension-funds sector. Low interest rates are forcing insurers and pension fund managers to buy assets in order to achieve their target returns. Their quest for yield is supporting the bond markets and limiting the possibility of any serious correction. The third key factor behind the solid uptrend is the activism shown by central banks in the last ten years. Central banks have pumped unprecedented amounts of liquidity into the markets, first to support financial institutions and then economic activity. Expected changes in monetary policy on both sides of the Atlantic should already have caused the bond yield curve to adjust. However, despite some temporary tension in the US, bond yields and spreads are remaining stubbornly low.
Will these three factors continue to support the current state of bliss? Or will common sense and prudence reassert themselves soon? We expect to find out the answer before the end of the year.
CEO Private Banking