Christian Crete

Marc Christopher Lavoie and Christian Crete, Portfolio Managers at Hexavest, an affiliate of Eaton Vance Investment Managers, note that escalating tensions between the U.S. and North Korea caused the CBOE Volatility Index (VIX) to jump after recently falling to historical lows.

In a recent commentary, they said:

Investor complacency and popular bets against the VIX are among the reasons why markets could see more turbulence following a prolonged lull, and why we think a cautious stance is warranted now.

The ‘short VIX’ trade

How quiet have markets been lately? The VIX Index, a measure of market expectations for near-term volatility, closed below 10 only 27 days in its history, 18 of which occurred since the beginning of May 2017. The recent levels of implied volatility of major stock markets around the world are in the first percentile of their historical distribution.

Shorting the VIX has become a very crowded trade, perhaps due to the increasing popularity of exchange-traded products that are linked to the volatility index. Any further spike in market volatility could be exacerbated by the unwinding of these short positions, with potential ripple effects through important deleveraging of strategies that have become quite popular, like risk parity and volatility-targeting.

While some are pointing to the record level of net short positions on VIX futures as a potential cause for the current environment, volatility is also low in other asset classes such as credit, gold and 10-year bonds. Clearly, there are many forces at work here, all of which have contributed to suppressing volatility in financial markets.

The impact of central banks

The ultra-stimulative monetary policies pursued by major central banks have fueled equity markets through lower interest rates and massive asset purchases. With their combined purchases of more than $1.5 trillion per year over the last two years, central banks surely helped reduce volatility in markets. Even if the majority of purchases were in the bond market, we believe a significant portion of the money injection that resulted from these operations made its way into equity markets. The impact on investor sentiment is clear: Many perceive central banks as a backstop for markets, leading them to take excessive risks.

The U.S. Federal Reserve may very well start to reduce the size of its balance sheet as early as September, and we expect the European Central Bank (ECB) and perhaps the Bank of Japan to start tapering their quantitative easing (QE) programs in the coming quarters. If central banks contributed to the decline in volatility with their bond purchases over the last few years, we would expect volatility to increase if the era of unconventional monetary policies comes to an end.

Rising markets and falling correlations

The stable and continuous rise in stock markets around the world also helped suppress volatility. The lack of two-way movements has brought a sense of confidence to many investors, who reacted by increasing their risk exposure. The immediate consequence is a reduction in realized and implied volatility. We are in the second-longest bull market of the last century and the MSCI World Index^[1] rose for an eighth consecutive month in July, the longest streak since 2003.

The decrease in correlations between sectors and between individual stocks since 2015, a trend that has accelerated since the U.S. election last year, has also contributed to the decline in volatility of the equity market as a whole.

Preparing for more volatility

Assessing investor sentiment is an important component of our investment process. We have been concerned by the level of complacency in markets for a while now, concerns that have intensified recently. In our view, markets are significantly underpricing uncertainty.

In his financial instability hypothesis, economist Hyman Minsky argued that it is the long periods of low volatility that create higher volatility. During extremely calm markets, investors tend to purchase more and more risky assets and to increase leverage in their portfolios to amplify returns. This is particularly true in a “zero-interest-rate” environment, when investors are essentially forced to buy assets like high-yield and emerging-market debt to meet their return targets. We believe all conditions are in place for the market to experience a “Minsky moment,” or a swift market dislocation.

It is difficult to pinpoint what will trigger the next volatility spike and market correction, but what we know with reasonable certainty is that many investors have much more risky assets in their portfolios than they may be able to stomach. Many indicators also suggest that financial leverage is very high, notably Goldman Sachs data on hedge fund gross exposure and margin debt levels published by the New York Stock Exchange.

When volatility comes back, and it will, forced selling of risky assets could significantly amplify any equity market correction.

We believe a more defensive stance, higher cash levels and a focus on capital preservation are justified since we view the risk of a market correction as high. While we acknowledge that low-volatility market trends may continue for some time, we believe that investors who adopt a prudent strategy will ultimately be rewarded.

[1] The MSCI World Index is a broad global equity benchmark that represents large- and mid-cap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country.

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