Why Volatility Could Be Worse

Balls

With one Sunday afternoon tweet, President Trump reintroduced what had recently vanished from financial markets: volatility.  By Thursday May 9th, the VIX Index, which measures implied volatility on the S&P 500, had reached a four-month high. With a trade deal with China now in doubt, or at least less imminent, investors are reassessing their views on the economy and financial markets.

How much worse can things get?

To answer that, investors should focus on two factors, which are more quantifiable than the day-to-day news flow: expected growth and financial conditions. For now, the latter offers some comfort. While it is true that a complete collapse in trade negotiations would send stocks much lower and volatility much higher, easy financial conditions are one reason the recent pullback has not been more severe.  Even at 23 the VIX is well below its December peak and less than half the level it reached in February 2018.

Volatility Index

A few weeks back I discussed the interplay between financial conditions and the growth outlook. The key message was that financial conditions are central for assessing market volatility.  This is even truer when growth is soft, as it is today.  Fortunately, while growth is tepid financial conditions are considerably easier than they were late last year.

For example, high yield spreads remain about 25 basis points (bps, or 0.25% points) below the level from late March and 150 bps below the December peak. Long-term interest rates have also pulled back. At 2.45% U.S. 10-year yields are approximately 80 bps below the 2018 peak. Finally, while the dollar has strengthened a bit since, the Dollar Index (DXY) remains within its recent range. The bottom line: Outside of the stock market, most measures of financial conditions have eased. This is why most broad based measures of financial stress look much healthier than a few months ago.

Why is this important?

As I discussed back in April financial conditions ultimately explain the lion’s share of the variation in equity market volatility. In fact, a simple two-factor model, including high yield credit spreads and the St. Louis Financial Stress Indicator, has explained roughly 80% of the variation in the VIX during the past 17 years. What is it suggesting today? Assuming no change in financial conditions, volatility looks too high.

However, even in a post-QE world, financial conditions are not the only driver of markets; growth matters as well. The key risk is that the potential drag from tariffs is occurring at a time when economies outside of the United States are just starting to stabilize. Another disruptive period of trade friction represents a major risk for Europe and China. Should this occur, central banks may have little choice but to ease even more.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2019 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Why Investors Are Ignoring Political Dysfunction—for Now

Retro old microphones for press conference or interview on table. Vintage style filtered photo; Shutterstock ID 426481501

At this stage of the bull market, investors are contending with more than a few enigmas: Do valuations even matter? Will interest rates ever rise? And how do you explain the divergence between U.S. political dysfunction and the unnatural calm in financial markets?

That last one has become particularly troubling. Most volatility measures are near all-time lows while Washington appears in complete disarray. Nonetheless, investors are likely to continue to look past political dysfunction, at least as long as financial conditions remain this easy.

Back in May, I first wrote about the relationship between policy uncertainty and market volatility. As a proxy for political uncertainty I used the popular Economic Policy Uncertainty indexes, measures based on real-time news flow. At the time I suggested that while market volatility and policy uncertainty do move in synch, the relationship is not particularly strong. Other factors, notably credit market conditions and the near-term economic outlook, tend to be more important.

Since then, U.S. economic policy uncertainty has only risen. Although the index has been higher during the past three months, overall policy uncertainty is significantly above where it was pre-election. And yet the VIX Index, a common measure of equity market volatility, is at half of its November peak (see the chart below) and bond market volatility is about a third lower. As surreal as this seems, it is not inconsistent with history.

VIX Index

History lessons

In the past, policy uncertainty has been more likely to coincide with a significant spike in volatility when monetary and financial conditions were tightening. This was the case in the summer of 1998, during the emerging markets crisis. While the federal funds target rate was stable, credit markets had been tightening financial conditions since the beginning of that year.

Another example of this dynamic occurred two years later during the disputed 2000 U.S. election. In the fall of that year, U.S. policy uncertainty spiked along with the VIX Index, which nearly doubled from the summer lows. Not only was the U.S. faced with an unprecedented hung election, but the Federal Reserve (Fed) had been tightening in the 18 months leading up to the election. At the same time, credit spreads were up over 200 basis points (in other words two percentage points) even before the election.

Today we have the opposite set of conditions. Yes, policy uncertainty has increased and the Fed has been raising rates, but broader financial conditions are easier than they were at the beginning of the year: High yield spreads are tighter, the U.S. dollar is down and the stock market is having a stellar year. As a result, composite indicators of financial stress, such as the Bank of America Merrill Lynch Global Financial Stress Indicator, suggest less stress than in January.

What could change this happy state of affairs? A few possibilities. One is that policy uncertainty morphs into systematic stress—i.e. failure to raise the debt ceiling later this year. A more likely catalyst would simply involve tighter financial conditions, potentially a result of the simultaneous withdrawal of monetary accommodation by the Fed and the European Central Bank (ECB).

But as long as money remains relatively cheap and plentiful, investors are likely to stay unperturbed by political paralysis and dysfunction. When that starts to change, political uncertainty may suddenly morph back from farce into tragedy.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

What Low Market Volatility Does Not Signal

Telescope to observe the coastal landscape; Shutterstock ID 150394688; name: Ann hynek; Client: BlackRock; Publication: BlackRockBlog; Story ID: May Generic - Looking for Something

Wall Street’s fear gauge spiked last week amid Washington turmoil. Yet the VIX remains comfortably below its long-term average of around 20, after a stretch of near-record lows. Low volatility isn’t a signal to sell or of imminent sustained higher volatility, in our view.

The VIX represents current near-term stock market volatility levels. Very high VIX levels have been reliable buy signals. The opposite isn’t the case. Low volatility tells us little about the direction of future equity returns, our analysis suggests. There has been a wide range of returns in the three- and 12-month periods following daily closes of the VIX below 14.

S&P Following VIX

Focus on fundamentals

Periods of low volatility also do not imply that higher volatility is imminent. Low-volatility periods historically have lasted a long time. They have generally occurred amid economic expansion and predictable monetary policy, both of which we see today. Low volatility today likely in part also reflects investors seeking income by selling volatility in options markets.

We believe a steady economic environment should help keep equity market volatility relatively low, with a sustained and synchronized global expansion in full swing. We see few signs of late-cycle equity market complacency, with a broad swathe of stocks behind gains in major markets. Yet investors should be wary in asset classes where low volatility has encouraged many to herd into similar trades, we believe.

A move to a new regime of extended higher volatility would be negative for risk assets. It’s impossible to predict what could trigger this but candidates include a credit crunch in China and a much more aggressive pace of Federal Reserve tightening. Neither is our base case. We also do not rule out short-lived volatility spikes on risks such as further U.S. political turmoil. For now, we believe equity investors are being compensated to take risk, particularly outside the U.S. Bottom line: Look beyond short-term volatility and stay focused on fundamentals. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States or elsewhere. All other marks are the property of their respective owners.

Volatility Divergence

Big fishing reels on a boat in the ocean. These reels are used to catch big game fish such as Mahi-mahi, dorado, tuna, sailfish, swordfish sharks and marlin. They are used in tropical and cold water oceans.

Back before the holidays I highlighted what I thought was an unsustainable trend: low equity market volatility. Since then, U.S. equity market volatility has continued to decline; last week, the VIX Index—a commonly used measure of equity volatility—dropped below 11, the lowest level since the summer of 2014, before the U.S. travel ban-related selloffs sent the index climbing earlier this week to near 13. Still, the VIX is very low by historical standards, and this is occurring against a backdrop of considerable political uncertainty. What is causing this and can it continue?

Equity investors are enjoying an unusually tranquil start to the year, particularly in contrast to last January. Benign credit markets and a more robust economy deserve much of the credit. As I’ve written about in the past, equity markets rarely struggle when credit conditions are benign. This is why high yield spreads explain approximately 60% of the variation in the VIX. Back in late October high yield spreads were already low, at around 470 basis points (bps). Since then they’ve moved even lower, falling below 400 bps for the first time since the summer of 2014. As tighter spreads indicate more confidence, one would expect volatility to fall, albeit not quite to these levels.

The second factor driving volatility is economic growth, or more accurately, expectations for growth. This time last year investors were worried about another recession. Today they are raising their estimates for growth. Since the election, 2017 U.S. consensus growth estimates have increased by 0.2%. Most leading indicators suggest that despite political uncertainty, both U.S. and global growth are firming. Historically, expectations for accelerating growth generally coincide with lower volatility.

What’s the catch?

Investors outside of the U.S. equity market are not quite as sanguine. Currency traders, for example, are experiencing more volatility. The CVIX, which measures currency volatility, remains in the middle of its six-month range and approximately 10% above the autumn low. Treasury volatility, measured by the MOVE Index, displays a similar pattern and is roughly 25% above the October bottom (see the accompanying chart).

Volatility Markets

A similar dynamic is visible in non-U.S. equity markets where volatility is low but starting to rise. The European equivalent of the VIX, the VSTOXX, has bounced in recent days. While still very low, the index is up more than 15% from the January bottom. Having spent most of last week in Europe, I can report that investors there are more and more nervous, both about U.S. politics and increasingly their own. With pivotal elections scheduled in Germany, France, the Netherlands and possibly Italy, Europe has the potential to once again be a source of anxiety.

Back in the U.S., despite protests and rising uncertainty, optimism over tax cuts and deregulation are offsetting concerns regarding trade and immigration at the moment. This may continue to work, assuming Washington delivers on the aforementioned stimulus and reform. In the absence of that, today’s low volatility looks odd in the context of an increasingly uncertain backdrop.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

How to Prepare for Volatile Markets

Volatility

The last few years have been a relatively calm period for the US stock market, with few of the large swings that characterized markets during the financial crisis and the subsequent few years. But if the start of this year is any indication, 2016 may be more turbulent. What should you do with your investments to protect yourself from that possibility?

The answer might actually be “nothing.” The first few days of a year don’t necessarily predict how the rest of the year will turn out. And larger market moves don’t necessarily mean you should make any changes to your portfolio. Markets go up and down all the time, and taking no risk with your investments would mean you wouldn’t have the chance to achieve more than meager returns. But if you are worried about market volatility there are a number of ways to try to combat it, some more advisable than others.

One way to try to protect yourself is to directly bet on volatility so that you’ll profit if markets become more tumultuous. These types of bets typically involve complex financial products such as options or exchange-traded products based on an index of stock market volatility. While betting on volatility can work in the short term if you guess correctly, it’s generally a terrible long-term strategy. For example, the iPath VIX Short-Term Futures ETN, one of the exchange-traded products tied to volatility, has lost more than 99% of its value since early 2009. Unless you fully understand how these types of products work and the unique risks involved, betting directly on volatility probably isn’t a good idea.

A second way to try to counteract stormy markets is to shift some of your stock allocation into “low-volatility” funds. These investment products have proliferated in recent years and hold stocks that historically have had been less volatile. These funds can indeed help reduce the impact of choppy markets, but there’s no guarantee that the stocks that historically bounced around less will outperform during any one future period of stock market instability. It’s also worth considering that some of these funds may shift your exposure not just toward less-volatile individual stocks, but also more broadly to less-volatile market sectors (such as utilities). Changing your sector exposure isn’t necessarily good or bad, but it’s something to be aware of if you’re thinking about low-volatility funds.

Perhaps the simplest way to prepare for market turbulence is simply to shift some of your allocation in higher-risk investments (such as stocks) into lower-risk investments (such as bonds). Shifting your allocation doesn’t mean completely abandoning stocks—you don’t want to make it impossible to achieve your financial goals if stocks actually perform well—but rather making slight adjustments so that you’re more comfortable with how your portfolio is positioned. After all, if the possibility of more volatile markets is keeping you awake at night, that may be a sign that your portfolio isn’t properly calibrated to your risk tolerance.

How to Think Like a Long-Term Investor

Road

For investors concerned about what will affect the long-term growth of their portfolio, it can be difficult to focus on the right issues. Most financial news stories are produced for traders and others in the financial industry who are interested in daily market movements. After all, their paychecks can depend on what goes up and what goes down. But for long-term investors, the implications of what’s happening can be very different. Here are a few interesting—and perhaps counter-intuitive—ideas for long-term investors to keep in mind amid the din of financial markets:

1) Low valuations can be good. It’s nice to have a bigger portfolio, so it feels good when the values of your investments go up. But if you’re building up your nest egg, you actually want prices to be cheap so your money goes farther. You’ll end up getting the best outcome if valuations are low during the “accumulation phase” of your life when you’re buying investments and high during the “spending” phase of your life when you’re selling investments.

2) Volatility isn’t necessarily bad. The up and down movements of financial markets can be gut-wrenching. But if you’re making periodic investments over time, such as putting a portion of each paycheck into a retirement account, there can sometimes be a bright side to volatility. Since your money buys more shares when the market is lower than when the market is higher, the ups and downs may result in a larger portfolio over time than if the market had been flat. This phenomenon is similar to the idea behind dollar-cost averaging.

3) Standard deviation may be the wrong measure of risk. The riskiness of investments (or even entire portfolios) is often described using “annualized standard deviations,” which are statistical measures that can be used to estimate the range of possible outcomes for a 1-year period. But even assuming that these estimates are accurate, using them to estimate potential outcomes over longer periods of time typically means assuming that what happens in one year doesn’t affect what happens in subsequent years. In the real world this assumption isn’t true, so these kinds of estimates may overstate or understate how much risk you’re actually taking.

Avoiding the Low Volatility Trap

Stock market volatility—how much the market goes up and down on a daily basis—has recently been unusually low. Since July of last year the S&P 500 index of large US stocks has gone either up or down by more than 1% on only about 12% of trading days, compared to a historical average of more than 20%.

Stock Market Volatility

Such low volatility isn’t necessarily good or bad, although most investors probably appreciate not having the value of their wealth swing wildly on a day-to-day basis. But low volatility can also trick investors into making bad decisions that damage their long-term performance.

One cause of these bad decisions is regret. Low volatility typically occurs as markets rise: the recent tranquility has occurred in the middle of an almost 40% rise in the S&P 500 index since the start of 2013. When these kinds of bull markets occur, a natural tendency is to wish you had allocated more of your portfolio to stocks.

The effect of regret is compounded by recency bias, the tendency for people to predict what’s going to happen in the future based on what’s happened in the recent past. During periods of low stock market volatility, it can be easy to forget that stocks often move up and down quite a bit (at the nadir of the financial crisis in late 2008 US stocks rose or fell by more than 5% in a single day numerous times).

Regret and recency bias are normal, so it’s not always easy to fight them off. The result can be a low-volatility trap, where calm markets lull you into taking too much risk. The key to avoiding this fate is to honestly assess your willingness and ability to take risk, and then stick to a long-term strategy aligned with that risk tolerance. Sticking to your strategy may not always be easy, but it will increase your chances of achieving your long-term financial goals.