Factors Contributing Financial Market Volatility

OCEAN CITY — One of our expectations for 2014 was that financial market volatility would pick up. After all, equities had a blockbuster year in 2013 and the U.S. Federal Reserve (Fed) was slowing down its bond purchases. In recent months, however, volatility has dropped off significantly for several asset classes. Both the VIX index, a measure of volatility for the S&P 500, and the MOVE index, a measure of Treasury bond volatility, have been approaching their lows of 2007.

Several factors help explain these trends. The most notable is stimulus from major central banks that has buoyed all asset classes with additional liquidity over the last five years. The aggregate balance sheet of the central banks of the G5 countries (U.S., UK, Europe, Japan and Canada) now exceeds $10 trillion. Just this month the European Central Bank not only cut two benchmark rates to almost zero but went negative with the deposit rate for its lending to banks.

Some investors believe that the current situation resembles the persistently low volatility that culminated in the financial crisis of 2008. There is no doubt that an extended period of central bank backstopping and low interest rates has created an incentive for investors to take more risk. In the fixed income markets, for example, credit spreads of investment grade and high yield bonds have declined to near pre-crisis levels. Year to date, investors have pulled $110 billion from the safety of

money market funds and poured a net $45 billion into equities and $96 billion into bonds, according to BofAML Global Research fund flow data. Equity markets on average experience pullbacks of 5% or more three times a year, but there have been only four of them since 2011 as investors have bought on the dips.

However, absolute measures of volatility such as the VIX index are poor indicators of market selloffs. History shows that they can remain at low levels for extended periods as stock prices continue to rise. We pay much more attention to other factors such as economic growth, earnings, central bank actions and valuations, which play important roles in determining the direction of asset prices.

We do think that volatility is likely to move higher from here though. A number of risks both in the U.S. and abroad could shake investor complacency in the second half of the year. One uncertainty is the U.S. midterm elections. The run-up to midterm elections typically brings volatility with the prospect of a shifting political landscape, a possibility dialed up by last week’s primary voting in Virginia. In addition, the Fed may be a source of volatility for the bond markets with a spillover into equities as it winds down its bond-buying program.

The U.S. economy is another factor. The contraction of U.S. GDP in the first quarter of the year resulted largely from temporary factors, including severe weather and a drawdown in inventories. Another negative surprise, however, could reignite investor fears that this economic recovery is fading, and prompt a severe selloff in both equities and credit instruments such as high yield bonds.

Abroad there are several risks as well, including a housing market bubble or a shadow banking crisis in China. There have been bond defaults there already and we anticipate more as the domestic economy slows.

In addition, the renewed instability in Iraq has added to the geopolitical concerns with Russia and Ukraine and pushed oil prices to a 2014 high.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)