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Why is stock-market volatility so low?

Scott Berg  |  12 Apr 2017Text size  Decrease  Increase  |  

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While investors continue to enjoy strong returns from global equities, one nagging source of discomfort is the remarkably low level of volatility displayed by markets, especially given continued uncertainties on the macroeconomic, political, and corporate earnings front.

 

This perspective is demonstrated by the MSCI AC World Index returning 7 per cent year to date and more than 10 per cent since the US election, to 31 March, with resolute and largely uninterrupted upward momentum.

The calm nature of markets can be evidenced by realised equity market volatility falling to levels rarely seen in recent history.

While more return for less volatility is always a welcome perspective for investors, it is rarely a sustainable backdrop at such extremes.

Why has volatility been falling?

It is important to note falling volatility is in part a reflection of some positive real change in the global economic environment. Improving data includes an increase in global PMIs, which are now reaching levels consistent with a solid acceleration in growth.

Corporate profits, actual and expected, have also been steadily recovering. Meanwhile, global interest rates remain low and monetary policy remains accommodative.

So, why are we looking for reasons to be more cautious than consensus near term?

Despite the fundamental improvement, hope and sentiment have played a role in lifting markets, as consensus has shifted from despair to exuberance in the space of a year.

This positive shift has its roots in improving data, as well as the potential impact US policy change may have, despite a lack of concrete policy proposals from the Trump administration.

The implication such an acceleration has for cyclical segments of the global equity market has caused a wave of cyclical buying in the post-election period, a trend we are leaning against with a carefully contrarian stance.

Tax reform and cuts, fiscal stimulus, and deregulation certainly have a growth-centred foundation, as Trump seeks to implement policy to back his pre-election rhetoric. However, we remain cautious.

In many respects, while the market continues to look skyward to politics and macro data as sources of renewed hope, we believe now is the time to get stock-specific and to refresh the wish list of stocks that may be coming on sale, should any macro or political disappointment arise.

So, what are the risks to the low volatility environment ending and what are the implications for equities? While recent data has been positive, this is partly the risk facing stocks.

While we enjoy good news as fundamental investors, it is likely we will see the momentum in economic activity fade at some point, while our best estimate is the positivity around US policy is likely to miss a step at some stage.

Either scenario will give renewed fuel to equity market bears that have been temporarily silenced.

A long and bumpy bull market

However, it is important to note that all else being equal, we would remain buyers of our favoured stocks upon any such weakness.

Applying the courage of your convictions during times of pessimism has been crucial during this now very long and mostly bumpy bull market.

Aside from sentiment and economic improvement peaking near term, we are also conscious inflation, most notably in the US, is rising once more and creating some medium-term risks.

At this time, higher inflation is being seen as a reflection of the economic improvement. However, embedded in rising US core inflation is a growing wage inflation trend.

Pricing power for individual companies is therefore going to be an important feature in terms of defending margins and growing profits in the next stage of the cycle. As will debt serviceability and leverage, if US interest rates do follow a path of modest increases, as we expect.

Medium term, the dispersion of corporate earnings as companies monetise opportunities or disappoint in a new regime of raised expectations and raised valuations is likely to move equity market volatility upwards to more "normal" levels.

This should not be seen as a sign the equity cycle is ending, but that a period of unusually positive data and sentiment is normalising, creating renewed entry points for both the near-term cautious and the long-term contrarian.

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Scott Berg is portfolio manager of the T. Rowe Price Global Growth Equity Fund. This article initially appeared on the Morningstar UK website. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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