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Question of the Week - September 6, 2016

Question of the Week - September 6, 2016

Guest Post - Tuesday, September 06, 2016

What should we make of the lack of volatility lately?

Late summer is has traditionally been a time of lower investment market volatility, due to obvious vacation schedules, Congress being out of session and other lack of important goings-on. This has been a remarkably quiet period, however, with stock and bond markets seeing the lowest amounts of August volatility in several decades; the VIX is back down at 13, which is far below its long-term average of around 20. Europe is also as quiet, which is not as surprising, as many businesses take the entire month off. Interestingly, and surprisingly to many, European and British markets have shrugged off the Brexit scare quite quickly, although this is to be a long, drawn-out process with twists and turns no doubt to come in years ahead as the exit process is ironed out and agreements renegotiated—expect continued delay of the inevitable.

It is first helpful to look at the causes of market volatility. Often volatility is created and exacerbated by wide differences of opinion about the future direction of economic and financial conditions. This can create large market movements, as can exceptionally good or bad news related to assessments and forecasts of these conditions, not to mention unforeseeable geopolitical shocks. Under the surface, volatility stems from a continual reevaluation of potential probabilistic outcomes and constant changes in these various probabilities. Conversely, aside from the typical seasonal factors, a lack of volatility can stem from other possible causes, including investor complacency, a wait-and-see attitude about upcoming events (e.g., Presidential election, Fed rate moves), or a widespread opinion that assets are generally near 'fair value'. In the case of the latter, there could be just a much narrower consensus view of possible outcomes, so the range of possibilities around perceived outcomes has simply tightened.

This lack of 'dislocation' has surfaced in a variety of asset classes, both in equities and fixed income. A key starting point is how interest rates have consolidated at current low levels, with a lack of inflation proving persistent and slow economic growth a difficult-to-combat global phenomenon. The consensus view is a continued, lackluster environment—and perhaps even a 'secular stagnation' that appears to be increasingly priced in. However, it's important to note that, even if this is the predominating view, we're never immune to shocks. Perhaps the most unlikely shock (relative to consensus anyway) is that growth recovers to a stronger level than anticipated, necessitating sharper and speedier rate hikes. This could put a damper on the past-year rally in long-duration U.S. and non-U.S. government bonds, could jolt emerging market debt, not to mention place a headwind on the recent rally of 'high dividend' and 'low volatility' strategies, many of which have significant overweights to defensive/low-beta sectors like utilities, telecom and consumer staples that are now trading at premium valuations compared to their history and even the rest of the equity market. Many of these firms continue to offer compelling dividend yields and dividend growth compared to alternatives, like bonds, but 'no tree grows to the sky' as the old stock market adage goes.

The bottom line is that volatility tends to be a 'mean-reverting' statistic; while periods of low and high volatility can cluster and persist for a time, levels tend to drift back up or down toward longer-term averages.

Read our Weekly Review for September 6, 2016.

Read the previous Question of the Week for August 29, 2016.

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