The surge in equity market volatility this year has raised some questions about whether we are now moving into a more unpredictable environment. If this is being driven by genuine increase in investor uncertainty (related to rising risk aversion), this would indeed represent a worrying development. And it has to be said that the escalation in US-China trade friction does indeed offer an obvious explanation for such a shift.
But then, there’s something a little bit too obvious about this explanation. Perhaps more pertinently, it just doesn’t appear to sit comfortably with the big-picture global environment which is, actually, very supportive of investor sentiment. For one thing, it is widely acknowledged that while the US-China trade conflict is generating a lot of heat, the likelihood of a full-scale trade war is very low. But also, central bank policies remain predictable and gradual. Moreover, the global economy looks robust with very few signs of major imbalances emerging (such as credit bubbles or inflation pressures). We simply don’t appear to be in an environment that should fuel major investor risk aversion or uncertainty.
So where is this rise in market volatility coming from? The source appears to be much less threatening for investors - the instability of US tech stocks . This sector of the equity market has so few stable valuation benchmarks that it is strongly dependent on sentiment, much more so than more established sectors of the equity market. For whatever reason (perhaps related to regulatory concerns), tech market sentiment appears to be unstable at the moment. This is generating market fluctuations which, in turn, are driving historic (recorded) levels of volatility higher.
It is not, however, ‘historic’ volatility that investors should be nervous about. Rather, it is expected (or so- called ‘implied’) volatility, for it is this measure that presents the threat to future portfolio values. When markets judder as they have done in the last couple of months, the consequential rise in historic volatility feeds through into expected because there is a tendency for investors to presume that the near-future will resemble the recent past. But this tends to be a temporary phenomenon and subsides once markets stabilise. In contrast, a rise in volatility generated by escalating risk aversion and uncertainty is far more threatening and likely to be more sustained, with the potential to feed on itself. This generates damaging crosswinds for investors which can impair liquidity and depress market prices. It is important for investors to recognise that this is not where we are at the moment. To the extent higher volatility levels merely reflects instability in a specific sector of the market, this phenomenon does not, by itself, present a serious threat to the investment environment.
Don Smith, Chief Investment Officer
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