Financial markets in 2017 have been marked by historically low volatility. They have been unrattled by events that would normally at least cause short-term volatility, including significant escalation of geopolitical risks, slower than expected economic growth in the US and slow progress on issues such as tax reform and infrastructure spending. It has been quiet - possibly too quiet?

There's an illusion of calm in the financial markets, and it's something I've been thinking about alot recently. I believe that there are big opposing influences at play right now, which may be dampening volatility. On one side is the unusual occurrence of synchronised economic growth. Japan, Europe, emerging economies and the US are all growing at the same time, and even though it's at low levels, there's a real benefit from this synchronisation. But on the other side, the US Federal Reserve is increasing short-term interest rates and there's an increasing amount of geopolitical tension and rhetoric. North Korea's regular appearances in news headlines falls into the latter category.

I think these counteracting forces are mitigating each other, resulting in the appearance of low volatility. Dr. Dan Russell of the Graduate Program in Acoustics at Pennsylvania State University describes this phenomenon in sound waves: when two travelling sound waves move in opposite directions at the same frequency and amplitude, it results in a wave that appears to stand still, vibrating in place.¹

While this creates the perception of quiet, it is not the same as there being no vibration. If we relate this to the financial markets, it doesn't mean that things are calm. There's actually a lot going on, but the opposing forces are simply cancelling each other out.

The low volatility and valuation debate - asking the experts

With over 450 investment professionals around the globe, I don't need to debate the low-volatility environment alone. I recently asked some of our most experienced investment professionals how they are interpreting the low volatility.

One response brought a smile to my face. Anwiti Bahuguna, Senior Portfolio Manager on the Global Asset Allocation team, reminded me of Occam's razor principle. It is a problem-solving principle attributed to William of Ockham, who was an English Franciscan friar and scholastic philosopher and theologian. The principle can be interpreted as stating, "Among competing hypotheses, the one with the fewest assumptions should be selected." In modern parlance, "Keep it simple, stupid!" So, simply stated, conomic fundamentals and corporate earnings are good, and there is a lot of money moving through the markets (referred to as liquidity). Hence, performance in most risk assets has been strong in 2017.

Jeff Knight, Global Head of Investment Solutions, reinforced this idea by affirming that low volatility in financial markets makes sense given the low volatility and synchronisation of economic data. This chart shows how the volatility of real GDP, a key economic measure, is lower now than in any decade since the 1930s. Investors shouldn't expect a sudden burst of volatility simply because volatility is low today. Unlike extremely high volatility, which has a tendency to expire quickly, low volatility can persist for a very long time.

STANDARD DEVIATION OF REAL GDP (US)

Source: Bloomberg 2017.

The market's most widely-followed measure of fear and risk is the Chicago Board Options Exchange's Volatility Index (VIX). Is this a good measure?

Source: Bloomberg 2017.

Josh Kutin, Senior Portfolio Manager, Global Asset Allocation team: It's not that the VIX is a bad indicator of fear and risk, it's just that there are forces which are dragging it down. There is a lot of trading activity that is keeping the VIX low - I am mainly referring to trades where market participants are betting on the direction of volatility and shorting the VIX. When the market inevitably goes into distress we'll see the VIX go higher, after the fact. The VIX may be the right indicator of current fear but it is not predictive of future fear levels.

Maya Bhandari, Senior Portfolio Manager, Global Asset Allocation team: A chief "flaw" of the VIX is that it captures implied volatility in US equities only, which makes it tricky to interpret for global investors. I look at two deeper measures of risk aversion that include more asset classes - one for developed markets and the other for emerging markets. Both use equallyweighted indices that reflect sovereign spreads, credit spreads, TED spreads and implied volatility in currencies, equities and swaps. I tend to pay more attention to these broader indicators, and surveys that rate consumer and business confidence, than I do to the VIX when gauging fear and risk.

William Davies, Global Head of Equities set out the following table of opposing influences on investors. He analysed the complexity in financial markets and simplified it to focus on some of the key factors. This includes the influences of synchronised growth, monetary policy on interest rates, and geopolitical tensions that I mentioned earlier. It also highlights one of the primary concerns investors have, which is that valuations are high.

William doesn't think high valuations alone will derail equities. However, equities will face headwinds at some point as the supportive monetary environment recedes. In recent years we have seen numerous risks avoid becoming worst-case scenarios which has led investors to be increasingly prone to downplay the adverse outcome of risk, which is typical when the market is doing well. Awareness of and sensitivity to risk becomes ever more important as valuations rise.

As William pointed out, valuations are high. What does that mean for investors? In the table William mentioned the Shiller PE ratio, which is the Cyclically Adjusted Price Earnings (CAPE) ratio. Anwiti studied the history of this indicator. In short, the CAPE is higher than average but thi tends to lead to lower returns over the next ten years rather than prolonged negative returns. This doesn't mean financial markets cannot suffer short-term setbacks.

Melda Mergen, Deputy Global Head of Equities pointed out that while the S&P 500 Index appears to be making a slow and steady climb, there is a lot going on within the market. Melda's analysis showed that the list of sectors leading the index is regularly changing and relatively small clusters of stocks are driving the market average, particularly when the market is doing well. We can observe this behaviour, but can't be certain of the cause. We suspect the sector rotation is in part driven by flows into and out of passive ETF products as investors react to changing views on what is driving economic growth. The cluster effect may be caused by a similar trend. My theory is that the greater the confidence in broader and stronger economic recovery, the broader the participation of market participants - the rising tide lifts all the boats. But as this broad economic enthusiasm abates, investors' views on which sectors are attractive change and they seek out companies with individual growth stories.

The valuation question also relates to fixed income. The following is an excerpt from the response of Colin Lundgren, Global Head of Fixed Income, to my inquiry of how he thought the current market would affect fixed income investors who are stretching into riskier sectors for more yield: "The total return opportunity of high yield has diminished over the last 12 months, and the market is more fully valued. Lack of fear and volatility have lulled investors into demanding less yield for the risk they are taking, which has resulted in coupons around 5.5% for the riskiest fixed income asset class. Put more harshly, the coupon, or income payment, on fixed income is at or near all-time lows and I think the asset class will struggle to produce coupon-like returns in the next 12 months. That doesn't sound like a good risk-adjusted opportunity to me... investors shouldn't get lulled to sleep by the apparent peace and quiet."

Bottom line

There is significant difference between calm caused by no activity and the appearance of calm caused by competing influences. The appearance of calm relies on opposing influences being of similar impact - so even a change in the magnitude of one influence relative to the others could significantly increase volatility.

While current valuations are high in a number of asset classes, many of the fundamental influences are quite good. Our research suggests that higher than average valuations lead to lower returns, rather than prolonged negative returns.

¹ Daniel A Russell: Superposition of waves www.acs.psu.edu/drussell/Demos/superposition/superposition.html

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