Market volatility – back on the radar

Jon Griffiths contributed to the writing of this blog

Earlier this year the VIX 'fear index' reached its lowest point in over 7 years, falling to 10.32 on 3 July 2014. The index then spiked to over 26 in mid-October, before falling again in November to less than 13. What caused this spike in volatility? How do current levels of volatility compare to what history suggests we should expect? And to what extent does all of this matter?

VIX is a market estimate of future volatility, measuring how much investors are willing to pay to insure against movements of the S&P 500 over the next 30 days. It is driven by options trading; as investors see a larger degree of downside risk in the market they will look to hedge their positions through purchasing options. This causes their price to increase, leading to an increase in the VIX index. Looking at October, concerns about the Fed ending its QE programme, deflation in Europe, geopolitical tensions, and the Ebola outbreak have all been touted as playing a part in increasing investor nervousness and causing the resulting spike in volatility.

"October wasn’t actually such a bad month when put into context."

The long-term (~25 year) average of VIX is approximately 20. So when we consider July’s low point along with the fact that the average over the last 3 years is around 16, it is clear that we’ve been living through a period of very low volatility. An increase in the VIX to levels in the twenties is actually not such a strange event. In terms of asset prices and looking at UK equities in particular, whilst October felt like a bloodbath for investors, when we consider a 30 year time horizon approximately 20% of months have had greater falls. October wasn’t actually such a bad month when put into context.

So what has caused the low volatility environment we’ve been living in? Well, as we highlight in our quarterly note, we believe that the low levels of volatility experienced over the past few years are due to the near-cult status that central banks have attained in their ability to apparently solve all of the global economy’s problems. We see this status as being built on shaky ground. It may well be the case that central banks themselves are the cause of increased volatility going forward, as currently synchronised monetary policy regimes begin to diverge, leading to greater investor uncertainty.

Does all of this matter? Well, pension schemes by definition are long-term investors, and whilst volatility (in the equity market and in other markets) is rarely comfortable, it should not lead to any changes to a scheme’s long term strategic investment strategy. It should come as no surprise that we advise Trustees to hold a well-diversified portfolio to try to reduce the impact of volatility of an individual asset class on the overall portfolio. However there is no guarantee that we won’t see a repeat of the large upticks in correlations witnessed during the financial crisis, which led to diversification protecting investors a lot less then they’d expected.

In closing, we believe that the rosy picture that the financial markets have been painting over the last few years may soon be over. As monetary policy diverges (with existing unconventional monetary policy experiments ending and other perhaps beginning), we expect for volatility to tick up and for returns to be more uncertain, and therefore recommend that investors brace themselves now for the distinctly choppier waters ahead.