At an index level, equity volatility in developed markets has reached record lows in 2017. In the U.S. options market, the Chicago Board Options Exchange volatility index, also known as the VIX index, has averaged slightly less than 12 per cent, compared to an average of more than 19 per cent since the financial crisis.
Given the common — if incorrect — perception of the index as the gauge of investor fear, many see the current situation as a warning sign of a lack of caution and a harbinger of doom. The truth is simpler: the VIX index merely reflects the low realized volatility in equity prices, which in turn reflects a benign macroeconomic environment and a lack of significant economic surprises.
So how low is realized equity volatility?
The chart below shows that short-term S&P 500 return volatility has regularly come down to nearly six per cent per annum this year, levels more commonly associated with bond indices. However, we have been here before. The closest historical parallels are the 2005-07 period preceding the global credit crisis and the middle of the 1990s, just before a bull run in global equity markets. Other asset classes, such as government bonds and currency, have seen return volatility decrease as well, in some cases setting new lows.
For equities in particular, a significant driver of low observed index volatility has been a decrease in correlations within markets, rather than an unusual decrease in individual constituent volatilities.
Read: The impact of low-volatility equities on DC behavioural biases
The second chart below shows a relatively larger decline in average correlations than in average levels of the individual volatility of S&P 500 sectors in 2017. Simply put, there’s currently more diversification arising between stocks than for most of the history we consider. The situation constitutes a break with the persistently high correlations observed after the global credit crisis and perhaps signals a normalization to pre-crisis levels.
The low correlations suggest a high level of dispersion in investor views about the current and future drivers of returns and also a focus on alpha generation rather than broader beta timing. That means markets are focusing less on common macroeconomic factors and more on idiosyncrasies that affect individual markets and financial instruments. Some natural increase in index-level volatility is likely in the near future, however, as consensus positions become established and correlations stabilize at higher levels.
Some observers have suggested the impact of post-crisis accommodative central bank policies on investor behaviour has been a driver of the recent low volatility. The suggestion is that monetary policy in the United States, Europe and Japan has distorted the valuation in risk assets by providing a floor on valuations.
Read: Time to jump into Japanese equities: report
While central bank policy is important, it’s unlikely to have played a dominant role. The current situation more likely reflects the lack of significant macroeconomic risk events on the calendar, the absence of major economic surprises, improving corporate earnings and broadly benign global growth expectations.
Does low volatility mean investors are complacent?
It’s possible to answer that question by looking at derivatives markets. Options markets reflect the insurance premium demanded by sellers for taking on the risk of guaranteeing an asymmetric payoff on the underlying asset. The premium can be directly measured as the spread between implied and realized volatility, which is a transparent assessment of the price of uncertainty. Across all major equity indices, implied volatility measures mirror trends in realized volatility, declining to levels rarely seen in the past few decades. Perhaps surprisingly, though, the price of uncertainty has remained high throughout the recent low-volatility environment. That suggests that the level of short-term risk aversion by investors hasn’t markedly decreased and more likely reflects recent geopolitical events.
Read: 2017 Top 40 Money Managers Report: Investing in the age of Donald Trump
A measure of volatility itself is neither a reliable indicator of a bubble nor an impending market crash. The current regime of low volatility reflects an unusually volatility-accommodative macroeconomic and corporate environment. Some gradual normalization in the direction of average long-term levels is likely, absent catalysts for a more abrupt increase, such as central bank policy error or geopolitical events. For volatility to rise more structurally, we need to see developments that alter the expected path of the global economy. Market volatility is a symptom, not a cause.
Rather than worrying about low volatility, investors should consider the implications of different potential risk catalysts for future increases and determine how to diversify their portfolios accordingly.
Arne Staal is head of multi-asset quantitative strategies at Aberdeen Standard Investments.