Dave Mohr (Chief Investment Strategist) & Izak Odendaal (Investment Strategist), Old Mutual Multi-Managers


Most of our investors may find this hard to believe but for some time there has been a concern that markets are not volatile enough. Volatility is extremely low across a range of indicators, of which the CBOE Volatility Index (VIX) is the most closely watched. The VIX, also known as Wall Street’s fear gauge, is hovering close to its lowest levels since its creation in 1993, barely in double digits (Chart 1). It measures the implied volatility of the S&P500, since it effectively represents what investors are willing to pay for protection against declines (the more fearful, the more they are prepared to cough up). Actual or realised volatility (daily moves of stocks, bonds and currencies) has also declined in recent years.

Low volatility, it is said, is a sign of complacency among investors. The last time the VIX was this low was right before the 2008 crisis during which it exploded, hitting a record high of 80. Even the minutes from the recent monetary policy meeting of the US Federal Reserve (the Fed) touched on the topic, noting concerns that “subdued market volatility, coupled with a low equity premium, could lead to a build-up of risks to financial stability”.

Why volatility is so low is of course a matter of great debate but there are three broad arguments. Firstly, underlying economic volatility – i.e. swings in gross domestic product growth and inflation from quarter to quarter – has declined. Secondly, volatility has grown tremendously as an asset class. Rather than using the VIX as a hedge, billions of dollars have been speculating on the VIX and VIX derivatives, including a huge growth in the number of exchange traded funds (ETFs) that are bet on rising or falling volatility. Finally, with central banks providing a perceived backstop, investors have been buying into any declines, preventing dips from becoming drops. 

Turning hawkish?

This latter tenet – central bank accommodation – has come into question over the past two weeks, as officials from the European Central Bank, the Bank of England, the Bank of Canada and the Swedish Riksbank have openly spoken about potentially paring back stimulus as growth improves. Of course the Fed has already hiked four times since December 2015, and is set to continue gradually lifting rates and shrinking its balance sheet. Bond yields, which reflect expectations of future interest rates, have increased over the past two weeks. The US 10-year bond yield rose from 2.13% towards end of June, to 2.36%. The German equivalent yield jumped to 0.57%, the highest level in 18 months (Chart 2). Higher bond yields put downward pressure on equity prices. There was also a spill-over to emerging markets, which suffered bond outflows for the first time this year last week, while equity inflows fell to their lowest level since mid-January, according to JPMorgan.

Whether central banks will actually follow through remains to be seen. After all, inflation remains low across developed markets despite falling unemployment. Central banks work on the theory that tighter labour markets will push up wages, which leads to inflation. This has not been the case in practice. Case in point, Friday’s US jobs numbers: the US created 222 000 new jobs (ahead of expectations) and the unemployment rate was 4.4% but annual wage growth has barely budged at 2.5%. 

Central bankers are inherently uncomfortable with negative real interest rates and financial stability considerations might just tip the scales in favour of monetary tightening, which could prove to be a costly error. However, there is also a growing understanding that the consequences of hiking too late can be dealt with more easily than hiking too soon. Nonetheless, while volatility might technically be low, uncertainty is high. Unfortunately one can only tell after the fact if this is an inflection point in terms of market pricing of central bank policies.  

Local volatility

Locally, political and policy uncertainty is particularly elevated, while the domestic economic recovery is stuck in a low gear. Local markets have also always been more volatile than global counterparts. One source of volatility on the JSE in particular is commodity prices. Though the local market is no longer dominated by mining companies, basic materials (mining, energy and paper companies) comprise 20.0% of the FTSE/JSE All Share Index, compared to a 5.0% share in the MSCI World Index and 7.0% in the MSCI Emerging Markets Index.

Another major source of local market volatility is the exchange rate. The rand is a highly traded currency in global markets and sensitive to shifts in global sentiment, which in turn has a huge impact on local financial markets. The bond market loves a stronger rand, as it puts downward pressure on inflation. The equity market in turn likes a weaker rand due to the large share of resources companies, and increasingly, globally focused consumer companies. (Some of the latter, like Richemont, are listed on the JSE for purely historic reasons and have very little activity in the local economy.) Shares that are interest rate sensitive, like banks, retail and property companies, like a stronger rand but even here it is getting complicated as some traditionally “SA Inc.” companies have expanded abroad in search of greener pastures. There is also the unusual case of European property companies – most notably UK giant Hammerson – seeking a secondary listing on the JSE simply because of the great demand for hard-currency real estate assets from local investors. All this means is that the exchange rate will play an even greater role in portfolio returns in the future.

Rand weaker

The rand has sold off against major currencies over the past two weeks. Though blame was placed on the ANC’s proposal to nationalise the SA Reserve Bank (SARB), the underlying reason is a global risk-off environment, as markets re-priced expectations of central bank policy. Local political issues are relevant but usually much less than global factors. As the International Monetary Fund (IMF) noted in a detailed report on South Africa last week: “South Africa’s highly liquid financial markets are vulnerable to tightening global financial conditions as investors may reassess policy fundamentals, in the event of international policy uncertainty and/or a faster-than-expected normalisation of US interest rates.” The other main risk remains another downward leg in commodity prices. Gold in particular has come under pressure as it is traditionally viewed as a hedge against loose monetary policy.

As an aside, what matters for the SARB is not its private ownership, which is an anomaly in global terms – the private shareholders have no say in policy and get a tiny share of any profits, while the Bank’s governor is appointed by the President and its inflation target mandated by Treasury. What matters is that it is independent in its policy-making. This is a key issue for ratings agencies and bond investors, who always face the risk of having inflation eat away the value of fixed coupon payments. Throughout history politicians seeking re-election have placed central banks under pressure to lower interest rates, even if this ultimately leads to higher inflation. (As a recent example, Donald Trump fiercely criticised the Fed for not raising rates faster on the campaign trail but now that he is in office, he seems to be happy for them to stay low.) Nationalising the SARB is highly unlikely to change the way it conducts monetary policy. The Bank of England, founded in 1694, was nationalised in 1946 and given full operational independence over monetary policy only in 1997. It remains to be seen whether the SARB will react to the perceived challenge to its independence by maintaining a hawkish stance. However, the window to cut rates in response to lower inflation and a weak economy might be closing if global monetary policy trends are moving in the opposite direction.

What does all this mean?

Volatility is not always a bad thing. For investors drawing an income, it is problematic, which is why their portfolios should have a higher portion of more stable and higher yielding assets. The biggest problem with volatility is usually that it results in investors making rash decisions with long-term implications based on short-term market moves. Investors can be their own worst enemies in that regard. Investment professionals can also fall into this trap, which is why we like team-based managers and processes that mitigate behavioural biases. For us as long-term investors, volatility creates opportunities to add value through tactical asset allocation. While uncertainty is inherent in investing, at times the outlook can seem particularly foggy. It is for this reason that diversification is a cornerstone of our investment philosophy. 

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This edition

Issue 72