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A State of Dead Calm

24 Oct 2017

Alex Scott, Deputy Chief Investment Officer

As we write, stockmarkets are in the midst of an eerie calm. It’s worth understanding the historical context of just how extraordinary today’s conditions really are.

Equity volatility, in the US and Europe, has collapsed to the lowest levels on record. US stocks have gone more than 325 trading days (i.e. well over a year) without a correction of more than 5% – that’s unusual but not unprecedented. We have seen extended periods without a significant fall happen before: once in the 1960s; and two long stretches in the mid-1990s. Even smaller market bumps have become vanishingly rare – fluctuations of more than 1% on a daily basis are now few and far between. Again, looking at the S&P 500 in the US, data back to the 1950s suggests an average of around 40 days a year where the market rose or fell more than 1% (almost once a week i.e. that this sort of move is very normal).

In more volatile times, such as the mid-70s, the tail-end of the dot-com boom and the 2008-09 crisis, we saw markets move by 1% or more well over a hundred days a year. Given that there are around 250 trading days a year – that’s almost half the time. There have been periods of relative calm in recent memory, but nothing like this. We have seen just eight days this year where the US stockmarket moved by 1% or more, in either direction, and not a single day where it moved by more than 2%. No fund manager working today has seen anything like this in their professional lives.
“There is time yet for volatility to return, but if it does not, 2017 will stand as the least volatile year in over 50 years.”

There is time yet for volatility to return, but if it does not, 2017 will stand (on this measure) as the least volatile year in over 50 years. We have to go back to 1963-65 for the only other similar stretch since 1950 where there were three years of incredibly calm markets, with only a handful of 1% days in each of those years. Such calm cannot be permanent of course: that particular stretch was followed by a 20% fall through 1966. Most Brits tend to remember that year for other reasons, but in US financial circles it’s remembered as the start of a grinding sideways bear market that lasted more than a decade. So as late as 1978, the S&P 500 index traded below the levels seen at the end of the mid-60s dead calm. While there’s no particular reason to suggest that today’s period of calm will result in anything similar – stocks were hit in the 1970s by a sustained rise in inflation which looks very unlikely in today’s global economy – it is, at least, a useful reminder that nothing lasts forever.

Theories abound as to why stock movements are so calm, but, as ever in markets, there is no definite explanation for precisely why what’s happening is happening. Some point the finger at Quantitative Easing (QE), with central bank action dampening market volatility (why worry, if Draghi and Yellen have got your back?). Others suggest that investors are still under-risked, remain scarred by 2008 and wary of the next crash. As that fails to occur, and the equity market bears give up on waiting for disaster, there is a ready supply of buyers for every market dip, no matter how small.
“Theories abound as to why stock movements are so calm, but, as ever in markets, there is no definite explanation for precisely why what’s happening is happening.”

Optimists, meanwhile, might argue that more robust and sophisticated risk management across investor portfolios has also helped, allowing institutions to calibrate their risktaking effectively and take a very sanguine view of the world. This however seems unlikely; if anything, widespread adoption of similar risk management systems could encourage herd-like behaviour in a sudden sea-change in market environment, as their risk models recalibrate for an evolving market regime. Many different investors reacting to a sudden bout of volatility by trying to sell assets in a hurry could lead to much bigger changes in asset valuations than seem justified by fundamentals – the deep correction in early 2016, just 18 months ago, was a prime example of this.

Others have suggested that today’s calm simply reflects a kind of ‘shock fatigue’ – the last decade, and maybe the last year or two in particular, have seen so many unthinkable surprises that investors have become inured to shock. Markets, central banks and politics have twisted and turned so much that the seemingly impossible has become commonplace (or so this theory goes). Who would have predicted ten-year government bonds with negative yields, central banks cutting interest rates below zero and buying trillions of US Dollars’ worth of bonds – not to mention the political shockwaves of Trump and Brexit? Have we really reached a point where markets have seen it all and cannot now be surprised? Put charitably, it seems unlikely.

We might observe that markets are behaving in a highly unusual manner, but how does this help us? After all, today’s record-low levels of volatility may be unusual, but conditions like this can persist long enough to be very painful for any investor who predicts a change of environment and positions for it much too early. We are already very familiar with this dilemma. Our portfolios are currently tilted somewhat towards a cautious stance, as we try to balance a fairly benign economic environment against rather demanding asset valuations. Observing today’s dead calm in markets gives us no particular insight on when the financial weather will change, but reminding ourselves how unusual current conditions are helps us to be prepared for the inevitable when it does come.
“If markets can keep their unruffled demeanour, it could be a sign that belief is growing in a global economy that is robust enough to support a return to more normal monetary policy.”

So, what could act as catalyst to end the prevailing low volatility regime? Causes of a shift in market environment can be hard to predict, but if central bank QE has indeed been one of the causes of a low volatility world, we might approach the next month or two with a little trepidation. Central banks have taken huge pains to foreshadow their actions to investors and limit the scope for surprise, but the run up to Christmas is likely to see another rate hike in the US, the announcement of a new Federal Reserve Chair to replace Janet Yellen (whose term ends in February), a first rate rise in the UK for a decade and a confirmation that the European Central Bank will reduce its QE programme. If markets can keep their unruffled demeanour through these developments, it could be a sign that belief is growing in a global economy and that growth is robust enough to support a return to more normal monetary policy. Such a world might see daily volatility creep upwards slowly in the same way as it has declined – rather than the sharp spike that everyone seems so afraid of.

Alex Scott
Deputy Chief Investment Officer

Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority. Member of the London Stock Exchange. Registered office: 55 Bishopsgate, London EC2N 3AS. Registered in England and Wales number OC378740.

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