Is the return of volatility a return to normal?

During the whole of 2017 the S&P 500 had just eight daily movements of more than 1%. This was an extraordinary period of low volatility in a year in which the index recorded 12 consecutive positive months.

So far, however, 2018 has been something quite different. Already this year the S&P 500 has moved more than 1% one way or the other on 28 trading days.

Another incredible statistic is that the Dow Jones Index has experienced five of its 15 largest daily points drops ever in just the first few months of 2018. It has also seen four of its 20 largest daily points gains in this same period.

Locally too there has been far more volatility on the JSE. This has been heightened by the Viceroy reports on Capitec and the concerns over the Resilient group of companies that sent prices moving sharply downwards.

This return of volatility has been a major talking point amongst market watchers, and many investors are asking whether it is a signal that the risk in global equity markets has become heightened. However, many analysts believe that what is happening in equity markets now is far more normal than the extremely low volatility experienced last year.

“Investors were probably spoiled in 2017 and even 2016,” says Hannes van den Berg, a portfolio manager at Investec Asset Management. “The volatility that we have seen so far this year has definitely picked up, but historically its more in line with where it has been over the longer term. We have maybe forgotten how volatile equity markets can be.”

Portfolio manager at Old Mutual’s MacroSolutions boutique, John Orford, agrees.

“What we certainly wouldn’t have expected is for volatility to stay low for a long period of time,” he notes. “Markets don’t typically move in a straight line forever. So even if you’re in a bull market you will have periods where markets pull back and that will be associated with a spike in volatility.”

What’s behind it?

According to Brad Preston, the chief investment officer for listed investments at Mergence Investment Managers, there are two key issues that appear to be driving the volatility.

“At least in the US and probably globally we’ve reached the tipping point in terms of moving from quantitative easing to quantitative tightening,” he says. “There is also quite a lot going on in terms of macro risk, whether that is threats of actual armed conflict or potential of trade wars.”

This has also been taking place in a context where leading indicators of global growth have been coming off a little.

“There has been some concern about global growth slowing,” says Orford. “Not that it will be weak, but that the rate of change may be falling a little bit. We’ve also had some slightly worse-than-expected inflation data in the US, which has raised some concerns about the pace at which interest rates will go up.”

What is the risk?

This is not, however, an environment that should send investors running for the doors. Global growth remains positive, which is supporting company earnings.

“Our view has been, and is still, that valuations are extended in the equity market, but we don’t think that valuations on their own create a bear market,” Van den Berg says. “We are back to the traditional battle of rising earnings from a company perspective versus tighter monetary policy. You can expect that this tension playing out in the market will cause more volatility.”

For Preston, this is actually a far more “comfortable” environment than the one experienced last year.

“I think there was a point around when the market peaked in January when it was starting to look like global assets were moving in an exponential type of pattern where every day the market just goes up more than the day before, and that’s now been shown to not be very sustainable,” Preston says. “I think the fact that we are seeing daily moves of 1% or 2% is not particularity unusual and doesn’t mean that there is a significant amount of risk around.”

Where investors should perhaps be cautious, however, is in the valuations of some companies and potentially excessive asset prices at a time when liquidity is slowly being reduced.

“One example would be the poster child of the high liquidity, zero interest rate policy, which is Tesla,” Preston says. “You have high valuations on a business that seems to be very reliant on being able to raise additional capital. Something like that is very vulnerable to a change in this environment.”

AUTHOR: PATRICK CAIRNS

This article was originally posted at https://www.moneyweb.co.za/investing/is-the-return-of-volatility-a-return-to-normal/