Volatility outlook: a financial game of musical chairs
The current market dynamic is like ‘a game of musical chairs’ whereby any reduction in central bank liquidity could result in a severe correction, where the next most vulnerable asset could miss out on one of those few remaining chairs.
As a matter of fact, in 2018, while the Federal Reserve was in tightening mode, we experienced both one of the worst days (5 February) and one of the worst months (December) for global equities, as well as one of the worse years for multi-asset portfolios (with almost all asset classes negative on the year, including global bonds).
Don’t dismiss the Q4 2018 volatility spike as a one-off
The depth and intensity of December's market correction and volatility spike came as a shock to investors.
However, what looked like a very bad omen in December today seems to be being viewed as a minor statistical disturbance that is best quickly forgotten.
However, it would be unwise to dismiss December's volatility spike as a one-off.
Several explanations for this sudden and violent market behaviour have been suggested - fears of a hard Brexit, the US government shutdown and the threat of additional trade tariffs on China all played a role. Alternative explanations for this short-lived volatility increase have pointed to more technical factors, such as a rotation out of technology and growth sectors and hedge fund deleveraging.
But the fundamental factors behind the expected shift to a higher-volatility regime are slowing economic growth and the very poor market underlying liquidity. Two such volatility flares in less than twelve months is no coincidence.
These volatility spikes almost confirm that we are now in a very late stage of the economic cycle. Overlaying that with the structural headwinds of elevated debt levels, expensive valuations, weak growth, poor liquidity, frail geopolitics and trade wars, we think that the global economy could be entering a more challenging period, as fundamentally, there are ‘fewer chairs’.
We actually believe that 2017 was as much as an outlier (in terms of low volatility) as 2008 had been (in terms of high volatility) and that the process of normalisation towards long-term average levels will continue from 2018 into 2019, even without another systemic crisis.
Central banks turned the music on once again
In the midst of the weakness, monetary policy at the major central bank unambiguously turned more dovish during January 2019. These dovish positions helped equity markets to quickly recover December’s losses, suddenly transitioning from the worst December since 1931 to one of the best Januarys in fifty years.
Ultimately, we do not believe central banks want to upset the current economic cycle and are acutely aware of the need to be cautious. A Fed on hold would most likely result in the music continuing to be played and an extension of the business cycle. The (unintended) consequence of this is that more and more asset classes will be left standing without support when the ‘music stops again’.
The music (liquidity) may stop (dry up) once again
Forward-looking option implied volatilities collapsed to new multiyear lows and the move was both deep and broad-based across most asset classes, strikes and maturities. To add to this puzzle, trading volumes are continuing their secular fall. With the traditional short-term and sell-side providers taken out by regulation (e.g. Basel III, Dodd-Frank and bans), markets are now structurally very shallow, especially in the so-called over-the-counter segments, therefore asset price attractiveness to institutional investors is the only driver of liquidity beyond the central banks.
Despite equity markets registering very low volatility, flash crashes, spectacular squeezes and abrupt rotation are becoming the norm. This is because the combination of low volatility and low volumes inevitably forces yield hungry investors into crowded trades, which get challenged from time to time creating risk-on risk-off waves that test investors.
As we have learnt from the recent sell-offs, when volatility spikes, liquidity is not there to take risk off, exacerbating the short-term price action. These market dynamics are closely overseen by central banks, which systematically intervene or at least step up the dovish rhetoric when there is a technical over-extension of a sell-off, causing assets correlation to “melt-up”.
In their quest to control market volatility, global monetary authorities have tamed deflation but also unbalanced the “volatility of volatility”, which has been nicknamed the new “fear” index. If the volatility market is relatively stable, markets ability to forecast the near future is good. But, if volatility itself is volatile, market visibility becomes murky.
Counter-intuitively, it may not be the time to buy volatility outright and actually you ought to be very careful about which volatility you want to sell and which risk(s) to hedge. For example, VXX, which is a listed note that buys systematically into front VIX futures contract, - i.e. goes long volatility - has lost almost its entire value over the last ten years.
Add a line of defence to your equity portfolio
As previously mentioned, the cycle has been elongated and we may well be approaching its end. In addition, we are witnessing regime changes in the market, both in terms of volatility and interest rates. These changes are impacting the risk appetite of investors who may feel it’s time to add a line of defence to an existing equity portfolio. The question remains how to build and implement it.
We believe there is an important distinction between ‘short-bias’ and ‘tail-risk’ strategies, as they do not hedge the same risks. The former is meant to offset normal corrections while minimising the cost of protection; the latter is instead meant to kick in during extreme corrections and maximise the asymmetry of returns.
Hedging standard market corrections via popular hedges may be both expensive and ineffective at this stage while a valid alternative exists by going long risky assets together with an active defensive overlay.
Our dynamic overlay solution is a hedging strategy which reduces the exposure of a given portfolio dynamically, simultaneously aiming at minimising the cost of protection during “normal” market phases and maximising the effectiveness of the protection during “hectic” market phases.
To achieve both objectives, we combine the short bias and tail risk strategies, which enables us to be flexible and adapt the strategy to the market and volatility environment. With this strategy, we seek to improve the risk/return profile of a portfolio by reducing risk without compromising on returns. Such methodology recently proved its reactivity in 2018 when retail investors were forced out of some speculative products.
With this sort a defensive investment solution, we also aim to respond to the new challenges posed by the regime-dependent equity/bond correlation and to provide an alternative to balanced funds thanks to the more stable relationship between equity spots and volatility markets.
Our overlay strategy is highly customisable, can meet various needs and can adapt to a client’s existing allocation. It can be delivered in different investment formats and we only use cash efficient, listed and very liquid instruments.
In conclusion, it may be time to invest in equities - without taking the full equity (downside) risk - before the “music stops again”.
Global Head of Cross Asset Solutions
Strategy Head – Quantitative and Volatility Strategies