Market volatility unsustainably low as bonds and equities diverge

There is now a growing disconnect between low global government bond yields which appear to indicate that the global recovery of 2017 may prove transient and high equity market valuations which discount an extended period of strong profits growth. In addition, starting from Q1 17 there has been an astonishing and sustained decline in equity market volatility. While there is nothing which suggests a market regime change is imminent, we continue to believe that re-normalisation of monetary policy is likely to result in the re-normalisation of volatility, bond yields and equity valuations over the 2018-19 period. This is not in our view a good time to be seeking to maintain returns by increasing portfolio risk.

Despite a sequence of positive economic surprises on a global basis, global government bond yields stubbornly remain at remarkably low levels – 2.4% in the US, 0.36% in Germany and 1.2% in the UK. At the same time, the recent positive performance of equity markets has followed improving economic sentiment and strong forecast profits growth. As a result, there is now a striking disconnect between, for example, record high US equity markets and at the same time a quickly flattening US yield curve, Exhibit 1.

Exhibit 1: US yield curve continues to flatten (10y – 2y yield)

During this cycle, the use of bond prices as an indicator of future economic developments has been somewhat compromised by the substantial intervention of central banks in long-term bond markets. Previously, long-term interest rate pricing was largely left to market participants, outside of Japan. One of the benefits of market pricing is that the resulting market-implied expectations offered a relatively unbiased guide to future growth and inflation.

This led to a belief among investors that the bond market would sense a recession well ahead of the equity market. Any inversion of the yield curve was regarded as a strong signal in support of a slowdown. However in this cycle, our confidence in the yield curve as a predictor of a slowdown is moderated by the increased influence of central banks on the pricing of the entire yield curve.

For the equity market, high valuations imply a further period of strong profits growth. Current consensus forecasts indicate a further 10% profits growth for developed markets in 2018, following a similar performance this year. Notably, the dire earnings performance of 2015 has long been forgotten, even if the more typical pattern is for earnings estimates to start strong and ebb over the full financial year. The current stability in earnings forecasts us in our view key to strong equity investor sentiment.

However, it is anomalous in our view to have market volatility so low with such a large divergence in implied expectations between global equity and bond markets. We see little merit in chasing equity market performance at this point; this period of profits growth is priced-in, in our view. There also appears to be relatively little diversification benefit in owning government bonds at current levels as these already discount a further period of very low interest rates or slowing inflation. The lack of diversification opportunities should at the margin also imply higher equity volatility.

Exhibit 2: Close-to-close vol for Datastream world index lowest since 1973

Note: Chart shows 100-day average percent of days with > 25bps daily move.

A divergence between bonds and equities is not wholly unprecedented and a similar picture was in evidence during 2006/7 when the US yield curve inverted but equities continued rising. However, what we would expect to see given this divergence of market expectations is rising market volatility. It is a concern to us that volatility has remained so low. Low volatility has also contributed to an easing of broad US financial conditions even as the US Fed has raised interest rates this year, through compression of bid/ask spreads and lower credit risk premia.

Given the strength of corporate profitability and near-term economic momentum, we believe it would be too brave to try and call the top of the cycle. Our base case is in fact a benign scenario for the economic outlook but with relatively little prospect of further strong near-term gains in equity markets, due to current valuation levels and rising interest rates. Delivering returns is likely to require a sharp focus on specific company or sector calls. Despite the current fashion for passive or ETF investing in hindsight this may prove to be better environment for the active manager.

Exhibit 3: Record high CBOE skew index shows downside protection still in demand.

The current ultra-low volatility regime is a mystery for which we do not have a good fundamental explanation. Volatility may be low but the CBOE Skew index which indicates the relative pricing of downside versus upside volatility remains at record levels, indicating that downside protection remains in demand. We believe investors should not be seduced into increasing equity risk exposure at this time of low volatility; the evolution of volatility in global equities has been highly mean-reverting over many decades. While we may struggle for a reason as to why volatility has fallen so far, the continued re-normalisation of monetary policy is in our view a valid reason to expect it to increase.