Andrew Baron, Butterfield
The return of market volatility over the first four months of 2018 has come at an interesting time in the global economic cycle. Over the last several years, and more particularly in 2017, volatility across a wide range of financial assets was extremely low. One commonly used indicator of equities market volatility, the Vix Index, averaged just above 11 in 2017. The figure 11 can be used as a proxy for a percentage annual volatility in stocks. So, in other words, if the Vix Index sits at 11, it means investors view the potential for upward and downward movement in stock prices to be around 11 percent. At no point in 2017 did the Vix Index close above 16.1. The essential problem with the market’s assumption of potential volatility last year is that it was very far below the actual historical volatility of equities, which have averaged approximately 16 percent over a very long time period, depending on which index one chooses to measure.
The unlimited liquidity provided by the developed world’s central banks, the likes of which the world has never seen, drove most of the low volatility phenomenon. Put simply, the Federal Reserve, the European Central Bank and the Bank of Japan bond buying programs were specifically aimed at forcing investors into risky assets and away from very low yielding “risk free” government bonds. Ultra-low or negative interest rates across the developed economies, coupled with these quantitative easing, or “QE”, programs that removed trillions of government bonds from the market, did not just suppress interest rates, they drove cross-border flows to other return-producing assets. This phenomenon contributed to the directionally positive markets for risky assets (equities, high yield bonds, etc.) that we have seen over the last five years, culminating in 2017, where equities rose on nearly every trading day.
Some of this excess liquidity is now being withdrawn, mostly via the U.S. Federal Reserve’s resolve to gradually reduce its asset purchases in order to shrink its oversized balance sheet. Financial markets, always forward-looking, are also beginning to handicap the end to the ECB’s bond purchase program, which by some accounts may start to shrink later this year. The reduction in central bank support is undoubtedly a fundamental change to the investment horizon, but it is important to put that change into perspective. Interest rates in the developed economies, although rising in the U.S., have not really changed in Europe and Japan and are still historically very low in the U.S. and elsewhere. Rates markets, in short, are still supportive of economic growth. The scale of any reduction in central bank purchases is also small in comparison to the sheer size of their bloated balance sheets. Any proper reduction in central bank bond holdings is measured in trillions, not tens of billions, and is many, many years from being complete.
There are also fundamentally positive reasons that central bank liquidity is being withdrawn. One should expect to see emergency stimulus being withdrawn at a pace appropriate to the global economy’s ability to continue on a self-sustaining growth path. This is just what is happening in the U.S. and what is being planned for Europe. Economic projections are for very healthy growth in 2018, both globally and in the U.S., which is still the largest economy in the world. The forecast for employment, again with particular emphasis on the U.S., is for continued positive momentum both in the quantity of jobs and in earnings. Corporate earnings are very strong and company guidance for 2018 has been pointing towards operating earnings growth figures we have not seen in many years. The U.S. economy has more recently been further supported by a highly stimulative tax regime for corporations and other fiscal measures. It would appear that Germany is also loosening its fiscal purse strings, although not in the massively under-funded fashion of the U.S. stimulus; this is Germany after all. The inflation forecast, whilst being materially higher than the past several years, is not for inflation to run rampant either globally or in the U.S.. Despite the gradual withdrawal of monetary stimulus, macroeconomic conditions do not suggest an imminent end to the business cycle, nor recession on the visible horizon.
Without the spectre of global recession on the medium-term horizon, increased two-way trading in equities – they actually do both rise and fall – does present some opportunities going forward. In addition to reasonable growth and earnings in developed market equities being supportive of looking through volatility and remaining invested there, emerging market equities outperformed substantially and managed small positive returns over the previous quarter, in U.S. dollar terms. While it is tempting to associate good emerging markets performance with good commodities performance, the reality is that their reliance on commodities has fallen and technology now represents 28 percent of the emerging market equities index. Investing in the emerging markets is no longer a bet on commodity price strength. Other historical myths regarding emerging markets exist as well. Emerging economies are still believed to be some of the most exposed to increased protectionism like those presently threatened by the U.S.. More recently, emerging markets have ignored this threat and for good reason. Most countries, save Mexico, do not derive the majority of their trade from the United States anymore. Indeed, China’s stated economic policies are specifically targeted at reducing their export reliance on the United States, with much greater emphasis on trade routes through Asia to Europe (overland) and intra-Asia (via sea). We believe that relative performance cycles are generally long and that we are only part way through this period of emerging market outperformance.
In summary, while the recent equities correction was notably sharp, when we look at the last several months in a historical context, what we have seen is a return to more normal levels of market volatility, compared to the abnormally low levels seen last year and a return to a more normalised interest rate environment. Investors would do well to follow the economic and earnings strength in the data and remember that higher equities volatility is a natural state of equilibrium, not a fear-inducing trigger to sell.
The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.