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Volatility: dead or in hibernation?

Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits – Hyman Minsky

Volatility is one of the first concepts that finance students learn to calculate, typically taught with reference to the variability of a stock or stock market’s returns, synonymous with risk.  At Antipodes Partners, we define risk as the likelihood of a permanent loss of capital and/or an extended period of negative returns. In this sense, whilst we seek to minimise unintended downside volatility, we actively embrace the opportunities that volatility can offer investors. Today, realised and implied volatility has fallen to record lows and buying volatility has been a losing bet for years across all asset classes, not just equities[1] (Chart 1).

CHART 1: REALISED CROSS ASSET AND S&P 500 VOLATILITY (1928-2017)

Chart 3
Source: Goldman Sachs Global Investment Research

Goldman Sachs have provided some useful recent work around the evolution of the current low volatility environment in the context of the long-term experience.

Some of the key observations include:

  • S&P500 index volatility is very close to an all-time low (Chart 1) and much lower than other global market indices (Table 1), though Antipodes Partners observes that low single security, as opposed to index volatility, is globally more pervasive, particularly in Developed Markets.
  • U.S. Treasury and credit index volatility is low relative to average levels post the 1970’s (Table 1), but not as low as the S&P 500. Antipodes Partners connects this outcome directly to central bank QE policies.
  • Cross asset index volatility is close to record lows (Chart 1)
  • Volatility typically spikes when equity markets fall as markets fall faster than they rise, however this doesn’t preclude the coincidence of rising volatility and markets, though this is rare (Chart 2)
  • Low volatility regimes are typically a late cycle phenomenon, the ending of which is difficult to predict but typically associated with rising unemployment/recession. However, the longer a low volatility environment persists, the greater the average equity market drawdown when it ends.

TABLE 1: S&P 500 VOLATILITY IS CLOSE TO AN ALL-TIME LOW(2017)

Table 4 without source
Source: Goldman Sachs Global Investment Research

CHART 2: S&P 500: VOLATILITY SPIKES WHEN THE MARKET FALLS (1928-2017)
Chart 4
Source: Robert Shiller, Goldman Sachs Global Investment Research, Antipodes Partners

In summary, there is nothing that unusual about the duration of the current low volatility environment. What is unusual is the low absolute level (and spread across sectors) of equity volatility AND cross asset index volatility globally.

As Minsky alluded to, prolonged periods of stability or low volatility do not necessarily equate with low potential risk. In fact, today many investment strategies are increasingly betting on stability and low volatility to generate returns.

Examining the mid-2000s, a virtuous cycle of cheap funding via surplus EM savings combined with a search for yield, resulted in low volatility which fuelled leverage in the developed world private sector. Today, we have a different issue with the central bankers now the key actors dampening volatility and creating the illusion of stability.

Antipodes Partners argues that volatility targeting investment strategies, such as risk parity[2] and minimum variance[3] are an OUTCOME of large scale bond buying programs, rather than the CAUSE of persistently low volatility. Hence, asset volatility, especially equity volatility, is not dead but rather in hibernation.

Furthermore, Antipodes Partners makes the following observations regarding the underlying nature of the current low volatility environment:

  • One of the primary objectives of QE is to cap the range and volatility of long-term government interest rates. Whether the merits for current QE makes sense or not, it’s hard not to argue that QE has successfully anchored long-term interest rate expectations and forced government bond holders to take an increasing amount of duration risk, lowering interest rates further and/or increasing allocations to other government bond markets, thereby supressing yields globally. Chart 3 highlights how aggressively certain central banks have targeted the longer end of the yield curve, with the weighted average maturity of central bank government bond holdings at 8-9 years for the Fed, ECB and BOJ
  • Whilst equity investors see themselves as central, it’s higher up in the corporate capital structure in credit where the impact of QE can be much more meaningful. As central banks have crowded private investors into high yield debt, spreads have compressed across the risk spectrum (Chart 4)
  • Now the cycle is in a virtuous period where low yields and low volatility reinforce the greater use of leverage to manufacture returns

CHART 3: SCALE OF QE AT THE LONG END OF THE CURVE (2017)
Chart 5
Source: Bank of Japan, European Central Bank, Federal Reserve, UBS, Antipodes Partners

CHART 4: PERCENTILE RANK OF U.S. HIGH YIELD (EX COMMODITIES) SPREADS VS. HISTORY (2006-2017)
Chart 6
Source: Deutsche Bank

Awakening from the slumber

Simplistically, we see two likely scenarios:

  • Growth surprises to the upside driving urgency from central banks to normalise policy. To minimise disruption to short-term funding markets, tapering would need to focus on the long-end of the yield curve leading to a potentially self-reinforcing pro-growth steepening, resulting in a significant increase in bond volatility and the death of the highly crowded/expensive equity low volatility, bond proxy and growth/quality trade. Conversely, it would be positive for the currently cheaper shorter duration equity exposures such as Banks and other so called cyclical sectors.
  • Growth disappoints via the withdrawal of global liquidity. For example, policy tightening in China combined with weak commodity demand has the potential to send a negative growth impulse to EM. In this scenario, credit volatility would spike triggering a major sell-off in credit sensitive equities regardless of their duration, i.e., a repeat of the 2015/16 commodity high yield melt-down which ended up spilling over into non-commodity exposures. Conversely, the inevitable central bank response would extend the illusion of stability and amplify the imbalances with a continued melt-up in the equity low volatility, bond proxy and growth/quality trade.

Whilst the recent sell-off in oil has many thinking the latter scenario is upon us, the market is somewhat already positioned for the end of the reflation trade. Crowding into bond proxies and growth/quality exposures remains intense, whilst speculative positioning in U.S. Treasury futures is at a record long (Chart 5), with the swing since early 2017 being nothing short of violent.

CHART 5: 10Y TREASURY NOTE NET NON-COMMERCIAL FUTURES POSITIONS (2012-2017)
Chart 7
Source: CFTC, Bloomberg

However, if U.S. growth expectations, which have thus far been very sticky continue to hold-up (Chart 6), we could see an equally violent rotation back to reflation exposures.

CHART 6: U.S. NOMINAL GDP FORECASTS
Chart 8
Source: Bloomberg

As we highlight in Chart 7, since the 1970’s there has been a tight relationship between average nominal 10 year U.S. bond yields and average nominal GDP growth, though we caveat this inference – in the 40 years following the Great Depression, U.S. yields failed to keep pace with nominal growth. In a cyclical sense, global growth has been accelerating for most of the year. Whilst we would hesitate to extrapolate a higher structural rate of long-term global growth, the recent move in rates highlights that global long-term bond yields may have been mispriced, i.e. too low, relative to growth and that this mispricing may be most extreme in the Eurozone.

CHART 7: EUROZONE BONDS ARE DISCOUNTING A STEEP DECELERATION IN GROWTH (2000 – 2017)
Chart 9

Source: Factset, Robert Shiller, Eurostat

Conclusion

Minsky’s assertion that the longer things are stable, the more unstable they become echoes against the current backdrop of extended low cross-asset volatility, one which we believe has created a false sense of security as investors confuse today’s low volatility environment with low risk.

Central bankers have somewhat cornered themselves. Increasingly, political and economic pressure to normalise interest rates or withdraw stimulus is likely to trigger volatility and widen credit spreads (our analysis suggests that U.S. high yield, or junk bond issuers are most vulnerable to this risk – see our research paper titled “The Global Corporate Debt Unwind”[4]). Whilst the low-volatility regime may endure, investors have grown too comfortable with the central bank reaction function, extending the illusion of stability.

At Antipodes Partners, we do not attempt to predict or time regime change. Whilst a poorly constructed building may eventually collapse, the cause, timing and degree is challenging to predict. As investors, we seek to identify where fragility exists and build a resilient portfolio with asymmetric payoffs at the stock, cluster and portfolio level, i.e. a safer building. At the core of our investment philosophy we seek in our long investments both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts, i.e. no margin of safety and multiple ways of losing. Whilst the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.

In our last quarterly, we noted that the blind assumption of unendingly low rates made the market vulnerable to a cyclical back-up in yields. Whilst this thesis initially played out and has partially reversed, we believe the risk is still asymmetrically priced. Accordingly, we are avoiding expensive versions of the bond proxies as long investments, accumulating selective opportunities that have suffered the most from yield curve compression whilst increasing our shorts on the beneficiaries of the low rate world, i.e. expensive bond proxies and growth.

In summary, we’re encouraged by the growing valuation dispersion within and across markets (region/sector/factor) as we think this is indicative of broadening pragmatic value opportunities, both long and short. Further, investment strategies which are seeking idiosyncratic alpha (rather than passive beta), are flexible and risk-aware should outperform in an environment where volatility awakens from temporary hibernation.

[1] https://www.bloomberg.com/news/articles/2016-06-24/europe-s-top-volatility-hedge-fund-sees-no-model-for-guidance
[2] Risk parity, or risk premia parity, is an approach to portfolio management which focusses on the allocation of risk, usually defined as volatility, rather than the allocation of capital
[3] Minimum variance strategies seek to exploit an observation that stocks with low volatility, in the right combinations, produce long-term returns equal to or better that the market at lower levels of risk
[4] http://antipodespartners.com/wp-content/uploads/The-corporate-debt-unwind.pdf