Volatility is cyclical, and right now it is at a cyclical low, driven down by global rate cuts and accommodative monetary policy. Investor complacency has reinforced the environment over the last several years as market pullbacks have typically been followed by strong rebounds. However, important policy events in the second half of 2017 could bring volatility back to the forefront. We believe investors should plan for volatility and focus on building well-diversified portfolios to withstand the inevitable return to a higher-volatility world.

How low can you go?

Low volatility environments can last for some time and tend to be self-reinforcing. To some degree this is chalked up to human nature: if the ocean is calm, there is a tendency to swim out further than you otherwise would, and to lose track of the risks of being farther from shore. We see this with institutional investors as well. Many use sophisticated risk models that rely on recent historical volatility as an input. When volatility is low, risk models give money managers the green light to take larger absolute positions, and to invest further out on the risk curve.

This is the financial environment of today. Volatility has been trending lower since 2012, with a brief increase in late 2015 as global equity markets swooned.1 There are many ways to measure volatility. The most often relied upon volatility gauge is the VIX, the publicly traded CBOE volatility index, which measures one-month volatility in the S&P 500 Index. Other common measures, like the Merrill Lynch Option Volatility Estimate Index (MOVE), are also near multi-decade lows.2

10% 15% 20% 25% 30% 35% 40% MARKET VOLATILITY IS NEAR RECORD LOWS 1991 2017 Source: Chicago Board Options Exchange, FS Investments.Note: S&P 500 Volatility Index (VIX), 1 year m.a., Jan. 2001—June 2017.

One of the most powerful drivers of low volatility is liquidity in the financial market. During the 2007–2008 financial crisis, the Fed slashed interest rates. Over the next several years, further measures proved necessary to stabilize markets, and the Fed expanded market liquidity by buying assets and building up its balance sheet. Along with other central banks from around the developed world, as interest rates and asset purchase programs accelerated, the globe was flooded with liquidity. These conditions helped to drive volatility lower.

Easy monetary policy has helped drive volatility down in another way. Since 2010, many market disruptions have been met with either further easing of monetary policy or by the Fed backing off of intentions to remove policy accommodation. Witness the “taper tantrum” in 2013, when the Fed reacted to market concerns about the winding down of its asset purchase program by ultimately purchasing over $1.5 trillion of assets in the open market, further expanding its balance sheet.3 To a lesser degree, in January 2016, when falling Chinese equity markets affected U.S. equities, the Fed backed off of its initial prediction of four rate hikes in 2016 and, in the end, only managed one.4 In short, each market pullback was quickly met with asset-boosting policy responses, and markets rallied in response. This recurring pattern has reinforced the belief that markets have nowhere to go but up, which has further pushed down volatility.

It’s alive!

Yet to think that volatility is gone for good is to fall for an age-old trap of Wall Street, where investors get lulled into a false sense of security. In 2017, a list of events is stacking up, any one of which alone could spark a rise in volatility as markets re-evaluate current growth and monetary policy expectations.

Fed balance sheet unwind: the Fed now expects to begin chipping away at its $4.5 trillion in assets in late 2017. Markets have few details as yet, but any reduction in the Fed’s balance sheet will be a tightening in monetary policy. Given how much excess liquidity there is to unwind, there is significant potential for a market disruption.

U.S. debt ceiling negotiations: the U.S. Treasury will need to address the looming expiration of the debt ceiling in mid-October. A U.S. government shutdown is a relatively rare occurrence in the modern budget process, but grumblings could very well spark higher volatility.

Dealer’s choice: geopolitics, reversal of the European Central Bank’s and Bank of Japan’s extraordinary monetary policy easing, Brexit negotiations – there is no shortage of events on the horizon that could impact markets and send volatility higher.

Volatility is cyclical

Volatility is strongly cyclical. This isn’t a financial theory, but a statistical fact. In other words, it isn’t a question of if volatility will rise again, but when. And rising volatility will almost certainly have negative implications for equity market performance.

A simple statistical analysis shows that volatility is strongly mean reverting. Put simply, over time volatility naturally drifts back to an average level that has been remarkably stable over the last 25 years.5 The long-term mean value of the VIX is 19.6, significantly higher than 11.6, the 2017 year-to-date average.6 The fact that volatility has demonstrated strongly mean-reverting characteristics means that investors need not focus so much on the cause of higher volatility, but should instead understand how higher volatility will impact their portfolio.

The monthly correlation between the VIX and S&P 500 has averaged 81% so far in 2017, significantly more than the 35%–62% average correlation in years prior to 2009.7 All of this adds up to the fact that when a correction higher in volatility occurs, history tells us it is likely to coincide with a sell-off in equities.

When this low volatility cycle comes to an end, investors will need investments that have a low correlation with traditional assets to dampen portfolio volatility. Financial news bombards investors with distracting headlines of what could cause volatility to rise. However, a spike higher in volatility is typically – practically by definition – unexpected. Preparing in advance for a higher-volatility world through a diversified portfolio of uncorrelated assets will be critical for investors.

Learn more:

1 Macrobond.

2 Bloomberg.

3 U.S. Federal Reserve.

4 Bloomberg.

5 The complete daily data set from January 1990 to June 2017 was tested using an Augmented Dickey-Fuller test. We can conclude with over 99% confidence that VIX is a heavily mean-reverting time series.

6 Average from 1/2/2017 to 6/30/2017, Macrobond, FS Investments.

7 Macrobond and FS Investments.

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