NN IP: Low volatility does not equal complacency

When we look at the low realized volatility in equity markets, it looks as if investors went into hibernation. Especially the US market volatility is far below its 30-year average (6.1% versus an average of 13.2%). Also the implied volatility has dropped. Earlier this month, the VIX fell below 10, a rare event, and the VSTOXX below 15. This raises questions whether investors have become too complacent.

There are several reasons why volatility is low. Several risk factors have faded over the past period. Brexit is in the UK a hot topic, but outside the UK and for financial markets it is not. The election of Donald Trump came as a shock but from a market point of view it is “so far, so good”, even if the actual delivery of several campaign promises is sub-par and every week has its scandal. In the Eurozone, political risk was also high with elections in the Netherlands, France and Germany. So far, the populist threat has not materialized and with the pro-European Macron elected president in France the probability of a material reform of the labour market has increased. Also the Eurozone project could receive a new push forward. In Germany it will be a battle between CDU and SPD, but with the odds in favour of the former. There is a high probability that Merkel will succeed herself as the next German Chancellor, warranting continuity in policy. So investors are currently decompressing from these political risks.

Corporate data were another point of attention. The first quarter results were better than expected in all regions and for most sectors. Also the quality of the earnings beat was good, as sales surprised positively and the surprise came against a non-lowered bar. As a result, expectations for full-year earnings have been ratcheted up. Growth in the mid-teens looks realistic, even without a US tax deal.

An interesting observation that helps explaining the drop in index volatility is the decline in intra-market stock correlation. This means that the common macro drivers that are responsible for the risk-on/risk-off trades over the past eight years are playing a less important role and are being replaced by more sector- and stock-specific drivers.



The macro data have also become less volatile, as the global economy has left the deflation risk largely behind and is witnessing a synchronized recovery that has further legs. For equity markets this is important, as bull markets do not die of old age but because of increased recession risk. That risk does currently look far away.

Finally, central banks try to become more transparent on their reaction function in order not to take the market by surprise. In fact, being more predictable in the long term but less so in the short term helps to build confidence without creating excessive risk taking.

But can we already talk of complacency, being a situation whereby visible threats are ignored or minimized? A way to look at this is through sentiment and positioning data. Investor optimism has increased but is far from euphoric. This is illustrated by the bull/bear ratio which is rather neutral. In addition, cash levels in investor portfolios are still above average. Our own uncertainty index, based on the analysis of news and social media content, has improved but is still below levels that prevailed in 2016.

Stability creates instability

So what could be the next source of volatility? There are several candidates. There is the geopolitical situation, with the soured relation between Russia and the West, the North Korean nuclear threat and the situation in the Middle East. A cybersecurity incident undermining confidence is another potential source. It is difficult to assess properly or to time accurately and to account for, but something that investors should not lose sight of.

Also a shift in central bank policies, whereby the unconventional measures are gradually scaled back, could be a source of volatility. As said, we think that central bankers will tread carefully to prevent disruptive market turmoil.

And of course, there is a possibility that this calm will indeed morph into complacency, which will eventually result in unwarranted risk-taking and higher volatility. Stability creates instability.