Plain sailing?

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We are more than a quarter of the way into the year which has promised much in the way of excitement and drama ‑ and delivered very little. For most investors, that is good news, even as it is not such good news for those looking to profit from volatility.

Indeed, the VIX index of equity option volatility shows levels of volatility not quite matching those of last summer, but at a little over 13, we are close. Indeed, volatility by this measure has fallen by almost 59% from its December peak. The Merrill Lynch MOVE index of option volatility, shown on Chart 1 below, capturing one-month Treasury options, has not matched its equity counterpart in absolute level, but the trend is exactly the same. Ten-year US Treasury yields have spiked to a little over 2.2% this year and troughed at 1.64% at the end of January, but apart from these brief moves, the yield of -1.87% at time of writing is one that would not have surprised Treasury market participants on most of the trading days of the year so far. Similarly, the index change of the S&P 500 is 1.08% year-to-date.

Of course, this may be seen as a US-centric view of asset markets, their importance notwithstanding. German yields have relentlessly rallied all year, with the betting being when 10-year Bund yields may turn negative. The euro ended the year at €1.2098/US$, and it has fallen by 22% year-to-date. External emerging markets have generally performed well, with the CDX-EM basket tightening nicely over the year—though baskets disguise a lot of movement within them—but local emerging markets have performed poorly for US dollar investors, owing to the further repercussions of US-dollar strength.

Despite the experience of lack of volatility being universal, the point stands, though. In this, the year that the US Federal Reserve (Fed) will likely hike rates for the first time in nine years, the Bank of England may follow suit, the European Central Bank (ECB) has embarked on a quantitative easing program larger than the stock of debt it is trying to purchase, it is not immediately obvious why volatilities should be so low. It does not stop there. Chinese growth continues to track downwards in what does seem to be an impressive feat of macroeconomic management, but with market participants now embracing sub-7% growth. This says a lot about China, but also about emerging market growth trajectories more generally.

We have not even covered Greece. We remain of the view that “Grexit” is improbable. There is also a role for a capital controls regime along the lines of the program put in place for Cyprus, though how this would operate is not at all obvious. Likely, though, we would not see Greece “crashing out” of the euro. Equally, we are still firmly of the view that many observers very significantly underplay the risks if Greece were to leave. The refusal of the International Monetary Fund to entertain a modification to the loan package and the clear irritation Greece’s European partners are expressing with the ruling Syriza party’s posturing mean that conviction and common sense are to an extent products of hope over what we actually observe.

The second of the possible European tragedies in previews right now is the “Brexit”, or UK exit from the EU. With its election well underway, the outcome is too close to call   and there is a bewildering array of combinations of parties depending on how many seats are won. The central cases are, first, that the governing Conservative Party is returned. Prime Minister David Cameron has committed to an in-or-out EU referendum, and it is by no means certain that the UK would vote to remain in. For Western Europe’s second-largest economy to commit economic self-harm of this order could affect the feeble growth in Europe in general quite negatively, to say nothing of the UK itself. The other outcome is the left-leaning Labour Party coming in to government, in a coalition with the Scottish Nationalists who would have just eviscerated it in that country. This, in turn, raises the real prospect of another referendum, which would be closely watched by other secessionist groups across Europe.

All of these ignore perhaps the most obvious case of a rise in volatility, which is the Federal Reserve. While the Federal Open Market Committee all but ruled out a June hike, September remains very much on the cards. We also cannot take that for granted given recent softness in US data, some of which may again be seasonal   we saw this last year for the same reason. Furthermore, the much lower oil price really must act as a stimulant for the wider economy, and the news is all in one direction: the optimistic tone of the nuclear weapons negotiations with Iran being just the latest example. When the Fed moves, more often than not, this is associated with periods of heightened volatility: the taper tantrum of 2013 is one recent example, though the phenomenon is well-observed.

So currently, it is plain sailing in markets, by and large. Investors can choose to imagine themselves perhaps tanning on the deck, enjoying the sun. There is certainly time for that. Equally, it is sensible to use these occasions to make sure the masts are steady, the sails in good order, and the ropes strong. Storms happen. And as much as we see the sun in every direction, the long-term radar paints an uglier picture of what may be just over the horizon. Now is not the time to double-down on risk allocations.

Chart 1: VIX Equity Option Volatility Index 13/04/2013 – 20/04/2015

VIX

Source: Bloomberg, as of April 17, 2015

Alex Johnson

Head of Absolute Return Multi-Sector Fixed Income

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