COMMENTARY
Macroscope
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The stock market ‘fear gauge’ is at a 23-year low, so what could go wrong?

The prevailing view, which was brought to the fore last week, that the withdrawal of policy accommodation by the world’s leading central banks will be the decisive catalyst for a surge in volatility is questionable

PUBLISHED : Thursday, 06 July, 2017, 12:22pm
UPDATED : Thursday, 06 July, 2017, 10:40pm

It has become an all too familiar pattern.

First, there are the long periods of tranquillity. Then, there are the fears that complacency has set in and that something is bound to disturb the calm. Finally, there is the event itself which, after a bout of turbulence, does little to change the landscape.

Welcome to Wall Street where every threat – political, geopolitical, economic and financial – that has triggered a deterioration in investor sentiment over the past several years has been insufficiently disruptive to put an end to ultra-low levels of volatility.

The facts speak for themselves.

Markets are likely to be put to the test only when investors sense a regime change in monetary policy is taking place

The Vix index, Wall Street’s so-called “fear gauge” that measures the anticipated volatility in the benchmark S&P 500 Index, has risen significantly above its long-term average of 20 points only once since the euro-zone sovereign debt crisis six years ago and currently stands close to a 23-year low. The Vix’s average level this year has been the lowest in the index’s history.

Even last week’s turmoil in government bond markets stemming from concerns about a coordinated withdrawal of monetary stimulus has, for the time being, failed to dampen investors’ appetite for risk. According to JPMorgan, in the week to June 28 – the day after hawkish rhetoric from the European Central Bank put sovereign debt markets under strain – emerging-market equity funds attracted a whopping US$2.5 billion in inflows, 32 per cent more than in the previous week.

Make no mistake, the resilience of markets is deep-seated and should not be underestimated.

The whirlwind of speculation about the possible triggers for a sharp sell-off should, at the very least, be counterbalanced by commentary explaining why markets continue to shrug off all sorts of risks and vulnerabilities and why sentiment may remain favourable for much longer than investors anticipate.

The prevailing view, which was brought to the fore last week, that the withdrawal of policy accommodation by the world’s leading central banks will be the decisive catalyst for a surge in volatility is questionable.

According to research from Goldman Sachs, which analyses 14 periods of low volatility dating back to 1928, a tightening in monetary policy on its own is not sufficient enough to trigger a sharp and sustained deterioration in sentiment. Dramatic surges in volatility occur only “after unpredictable major geopolitical events, such as wars and terror attacks, or adverse economic and financial shocks”, Goldman Sachs notes.

The fact that markets have remained calm in the face of three US interest rate rises in the past seven months and a plan by the Federal Reserve to begin unwinding its US$4.5 trillion balance sheet suggests that the bar to a surge in volatility is indeed quite high.

This raises some uncomfortable questions.

Have asset prices become so distorted by years of aggressive quantitative easing that markets have effectively been rendered comatose, desensitised to every risk – even a tightening of monetary policy by the world’s most influential central bank, and now signals from its peers in Britain and the euro zone that they will soon follow suit?

If Goldman Sachs is right and volatility remains subdued in the absence of a major financial or geopolitical shock, will frothy US equity markets – and other overpriced asset classes for that matter, notably emerging-market corporate debt – amplify risks in the financial system, supplanting central banks as the most likely source of a resurgence in volatility?

What is clear is that the longer markets remain becalmed and valuations continue to rise, the greater the scope for a much sharper and disorderly sell-off.

When exactly markets will turn, how severe the sell-off will be and what specifically will trigger the shift in sentiment remains unclear. For the time being, it is fair to say that markets have yet to be thoroughly tested.

Even the Fed, which is most advanced in withdrawing stimulus, is raising rates at a gradual pace and in a well-telegraphed manner. Other central banks, particularly the European Central Bank, are likely to tread even more cautiously, given how reliant investors have become on quantitative easing in Europe and Japan.

Markets are likely to be put to the test only when investors sense a regime change in monetary policy is taking place, with the pace and geographic breadth of tightening increasing – or at least perceived to be increasing – significantly.

Even then, one could be forgiven for doubting whether the surge in volatility will be as dramatic as many investors fear.

Nicholas Spiro is a partner at Lauressa Advisory

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