OCEAN CITY — Of the surprises investors have encountered this year, none may be more significant than the lack of market volatility. By any measure and across most asset classes, volatility has not only remained at extremely low levels for most of the year despite numerous geopolitical concerns, but has continued to fall — trending this way since the summer of 2012.
We have addressed the traditional question of whether low levels of volatility signal complacency in other writings — diversification and hedges are the portfolio solutions for a pickup in volatility.
In this weekly, we focus on where to consider investing in the equity markets as volatility rises. In a recent report, BofA Merrill Lynch (BofAML) Head of Derivatives Research Ben Bowler notes what he believes are several reasons for the “low volatility conundrum,” among them: low economic volatility that increasingly reflects smooth, consistent growth in gross domestic product (GDP); a scarcity of yield that has pushed traditional fixed income investors into
Equities; a change in investor psychology toward viewing central bank intervention as risk-reducing; and declining trading volumes driven by shrinking bank balance sheets and financial system deleveraging.
In our view, the reversal of these factors should serve as the cairns on the road to higher volatility. However, for many potential investors, the road to higher volatility is not one they want to travel; they prefer to wait for the road to clear. We think this could be a missed opportunity.
The BofAML U.S. Economics Research team forecasts a slow but improving growth trajectory, and while there are numerous risks to the forecast, the fundamental trends are well-anchored.
In our view, a rise in volatility likely signals a shift toward a stronger but bumpier pace of economic growth on the way to more normal levels and an inflection point where markets transition from being driven by policies of artificially cheap money to fundamentals of stronger corporate revenue growth.
After a long bull run in equity markets, higher volatility should present an opportunity to realign equity portfolios toward companies with cheaper valuations and exposure to potentially higher economic growth. The link between rising levels of market volatility and growth comes through interest rates.
Historically, the combination of attractive starting valuations and the quality bias of large multinationals has also been a bulwark against a pickup in volatility.
In the near term, the path to repositioning portfolios is likely to be a challenging one. Investors are becoming increasingly anchored to the thinking that what worked in the past will work in the future. This mind set is evident in what many of them are buying — exchange-traded funds (“hey, the market went up, I will just buy the market”) and dividend-paying stocks (“I need my income and since it went up I must be fine”). The dark side of the low-volatility environment in which we live is complacency. We think a number of events in the coming months could upset the inertia applecart and signal the rise of volatility sooner than many expect.
Among such events are the end of the Federal Reserve’s quantitative support program in October, a re-acceleration of capital spending (which is cycled back into corporate revenues) and unexpected shifts in geopolitical headwinds.
(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)