Investing in a possible dissipated liquidity and increased volatility environment
We are at a curious juncture economically. In the developed world, economies and markets have been propped up by the exceptional policy response undertaken by central banks. However, economic growth remains subdued despite the corporate sector and, incre
The central bankers seem to have more or less won the battle against deflation. Developed economies are ticking over and there are signs of improving consumer and business sentiment which, if they find traction, could be sufficiently powerful to eventually move the western economies back towards genuine self-sufficiency. This next phase will be a difficult one for central bankers, who will not want to remove their stimulus too early. They, however, risk elevated levels of inflation if the liquidity persists and the present financial sticking points ease up and allow a freer flow of cash through the system. In such a scenario, price inflation is a very real phenomenon. Perhaps it is already too late to speak of the risk of price inflation as it is already occurring thanks, in part, to the extraordinary volumes of liquidity provided by central banks. The only difference is these price moves are in the investment markets (rather than consumer prices).
The past year has brought with it excellent returns for investors in ‘risk’ assets. As we have moved through this 12-month period, confidence has increased and levels of market volatility have dropped. To put it another way, equity markets have been moving upwards in an increasingly linear fashion. This is not uncommon in the sense that bull markets often experience a phase where confidence is high and there are still buyers at the current market price. As of today, there are plenty of credible (and well-trodden) reasons for equity markets going up. After a significant market setback, such as that seen during the global financial crisis, it is understandable that markets would be oversold and that a rerating will take place at some point in order to bring valuations back to reasonable levels. The slight cause for concern here is that market participants have not done this by themselves, but rather relied on the extraordinary central bank measures seen over the past few years to drag the markets out of the doldrums. To an extent that is normal as central banks tend to cut interest rates at times of crisis, but continuing to offer the same scale of assistance for an extended period after the slump would not bode well for markets in the long term.
The chart depicting implied volatility (figure 1) demonstrates two phenomena. The first is that, from a historical perspective (particularly in the context of recent years), implied volatility today is low. The second is that implied volatility is starting to drift upwards.
We are at a curious juncture economically. In the developed world, economies and markets have been propped up by the exceptional policy response undertaken by central banks. However, economic growth remains subdued despite the corporate sector and, increasingly, consumer being in reasonable shape. There remain significant questions over the longer-term implications of the ‘walls of money’ that have flooded the system, as well as the scope and risks associated with any future unwind. What is clear to us is that interest rates will remain low for the foreseeable future and that the other extraordinary monetary policy tools must be wound up at some point, even if the support is not removed entirely.
The central bankers seem to have more or less won the battle against deflation. Developed economies are ticking over and there are signs of improving consumer and business sentiment which, if they find traction, could be sufficiently powerful to eventually move the western economies back towards genuine self-sufficiency. This next phase will be a difficult one for central bankers, who will not want to remove their stimulus too early. They, however, risk elevated levels of inflation if the liquidity persists and the present financial sticking points ease up and allow a freer flow of cash through the system. In such a scenario, price inflation is a very real phenomenon. Perhaps it is already too late to speak of the risk of price inflation as it is already occurring thanks, in part, to the extraordinary volumes of liquidity provided by central banks. The only difference is these price moves are in the investment markets (rather than consumer prices).
The past year has brought with it excellent returns for investors in ‘risk’ assets. As we have moved through this 12-month period, confidence has increased and levels of market volatility have dropped. To put it another way, equity markets have been moving upwards in an increasingly linear fashion. This is not uncommon in the sense that bull markets often experience a phase where confidence is high and there are still buyers at the current market price. As of today, there are plenty of credible (and well-trodden) reasons for equity markets going up. After a significant market setback, such as that seen during the global financial crisis, it is understandable that markets would be oversold and that a rerating will take place at some point in order to bring valuations back to reasonable levels. The slight cause for concern here is that market participants have not done this by themselves, but rather relied on the extraordinary central bank measures seen over the past few years to drag the markets out of the doldrums. To an extent that is normal as central banks tend to cut interest rates at times of crisis, but continuing to offer the same scale of assistance for an extended period after the slump would not bode well for markets in the long term.
The chart depicting implied volatility (figure 1) demonstrates two phenomena. The first is that, from a historical perspective (particularly in the context of recent years), implied volatility today is low. The second is that implied volatility is starting to drift upwards.
We are at a curious juncture economically. In the developed world, economies and markets have been propped up by the exceptional policy response undertaken by central banks. However, economic growth remains subdued despite the corporate sector and, increasingly, consumer being in reasonable shape. There remain significant questions over the longer-term implications of the ‘walls of money’ that have flooded the system, as well as the scope and risks associated with any future unwind. What is clear to us is that interest rates will remain low for the foreseeable future and that the other extraordinary monetary policy tools must be wound up at some point, even if the support is not removed entirely.
The central bankers seem to have more or less won the battle against deflation. Developed economies are ticking over and there are signs of improving consumer and business sentiment which, if they find traction, could be sufficiently powerful to eventually move the western economies back towards genuine self-sufficiency. This next phase will be a difficult one for central bankers, who will not want to remove their stimulus too early. They, however, risk elevated levels of inflation if the liquidity persists and the present financial sticking points ease up and allow a freer flow of cash through the system. In such a scenario, price inflation is a very real phenomenon. Perhaps it is already too late to speak of the risk of price inflation as it is already occurring thanks, in part, to the extraordinary volumes of liquidity provided by central banks. The only difference is these price moves are in the investment markets (rather than consumer prices).
The past year has brought with it excellent returns for investors in ‘risk’ assets. As we have moved through this 12-month period, confidence has increased and levels of market volatility have dropped. To put it another way, equity markets have been moving upwards in an increasingly linear fashion. This is not uncommon in the sense that bull markets often experience a phase where confidence is high and there are still buyers at the current market price. As of today, there are plenty of credible (and well-trodden) reasons for equity markets going up. After a significant market setback, such as that seen during the global financial crisis, it is understandable that markets would be oversold and that a rerating will take place at some point in order to bring valuations back to reasonable levels. The slight cause for concern here is that market participants have not done this by themselves, but rather relied on the extraordinary central bank measures seen over the past few years to drag the markets out of the doldrums. To an extent that is normal as central banks tend to cut interest rates at times of crisis, but continuing to offer the same scale of assistance for an extended period after the slump would not bode well for markets in the long term.
The chart depicting implied volatility (figure 1) demonstrates two phenomena. The first is that, from a historical perspective (particularly in the context of recent years), implied volatility today is low. The second is that implied volatility is starting to drift upwards.
Figure 1
Graph: CBOE VIX level, Source: Bloomberg, May 2013
We believe that this is a natural phenomenon and, from a tactical perspective, one we welcome, as, even with extraordinary monetary policy, markets will not go up in a straight line for an unsustainable period. Volatility is a feature of markets and one that can only be temporarily banished by our collective optimism. We will all be impacted by the uptick in volatility when it comes, but, by preparing ourselves, we can reduce its impact.
When considering the current volatility of the rand, the tendency to associate the resolution of the prevalent headwinds in South Africa (labour unrest, electricity supply concerns and possible further rating agency downgrades) with a recovery could be a little short-sighted. The currency’s performance going forward should probably also be considered within the context of central bank quantitative easing (QE) and market volatility in that increasing evidence of a ‘foot being placed on the QE brake’ could denote a strengthening of the dollar, which will prevent a significant rand retracement. Conversely, if US economic momentum stalls, confirmation of the QE status quo could induce a recovery in the rand.
The good news is that a period of consolidation will provide excellent buying opportunities. Today, as markets rise with the dual effect of liquidity and positive sentiment, it is becoming increasingly difficult to find cheap assets. Equities aside, government debt has been expensive for many years, but we are also now reaching a point where, if taken as a whole, investment grade credit and high yield are starting to look toppy. Indeed, any investors happy to simply buy the market beta in the latter are now likely to be holding a number of overvalued issues in their portfolios. Like equities, this is a market that should reward active management. A strategy that naively invests in purely high-yield securities should be particularly exposed to a market setback.
While it is still possible to make a medium-term bullish case for most ‘risk’ assets on valuation grounds, it is a difficult proposition in the short term. Looking to the immediate future, there is the hope that the epic scale of central bank policies will dominate all other factors. However, this is looking increasingly unlikely and it is therefore more important than ever to ensure that there are a variety of returns drivers included in your portfolio. Diversification and margins of safety are essential; this is especially so in an environment where the future of QE becomes uncertain. In that scenario, it is dangerous to be buying expensive assets in the hope that they will float higher on the back of central bank liquidity.
So, while a focus on valuation may be difficult in the short term, in the long term it may be one of the best means of protection if liquidity dissipates and volatility returns. This does not necessarily mean wild bouts of risk-on/risk-off behaviour, but it does mean that markets will perhaps be more discerningly priced than they are today. Volatility is rarely palatable, but a strong valuation framework, combined with discipline, expertise and critical judgment, can provide the means through which it is ultimately embraced, as is the opportunity to take advantage of the resultant mispricing.
