Volatility is Back with a Bang

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Sharp movements in markets have been a wake-up call for complacent investors, but should not have surprised anyone. The normalisation of monetary policy brings challenges to financial markets, but it is important to remember why policy is normalising: 10 years after the global financial crisis, economies are starting to stand on their own two feet again.

A rough ride

It may not feel like it for many investors this month, but volatility is the market’s friend. Corrections of the kind we saw in the early days of February perform several useful functions: they allow us to revisit valuations that have been lifted by a rising tide; they act as a reminder of the advantage of prudence and long-term thinking; and they moderate those ‘animal spirits’ that the economist John Maynard Keynes identified as the dark heart of financial markets.

The ride can be rough. The S&P500 posted steady and pretty much uninterrupted growth over 2017, but the gains in January 2018 were far steeper - exuberant even. It took a matter of days to wipe it all out. A jump in US hourly earnings data published on 2 February was enough to prompt fears that rising inflation might push the US Federal Reserve (Fed) to adopt a faster pace of interest rate hikes. The S&P500’s 6.5% gain in the first month of the year was followed by a fall of more than 10% in a week. US Treasury yields rose and stock markets fell around the globe, while the VIX index, which measures volatility, spiked to more than 50 on 6 February, the highest since March 2009. Some semblance of calm has since emerged, but these are the kinds of moves that can worry investors. This is a moment to consider market realities and examine the fundamentals at play in the global economy.

Recovery process

First, we must remember that we have emerged from an era of unusually low volatility. That year of gains in 2017 is not the normal course of events and it should shock no one that there was a sting in the tail. There have also been clear technical factors in this latest episode. A good portion of outflows appears to have resulted from trend-following strategies, as short-term price momentum signals turned negative. Market makers’ hedging of option positions also contributed. Volatility will likely be a feature of 2018, but it is equally likely that these technical aspects of the February drama will be less pronounced as we move through the year. It is also worth noting that the market’s sharp reaction to US wage growth served to make conditions tighter - with 10-year Treasuries heading above 2.8% and equity markets weakening – which may have been enough to stay the Fed’s hand if its thinking was as feared. Central banks, after all, like markets to do their job for them.

So why is volatility more likely? In simple terms, the world is still recovering from the global financial crisis and the era of easy money that followed. As central banks in the US, Europe, and maybe Japan, step away from accommodative monetary policy and remove liquidity, then markets will tend to over react. It is like a parent taking the stabilisers of their child’s bicycle. A few wobbles, and perhaps the odd tumble or two, are inevitable. To extend the analogy, the important thing for investors will be to assess the roadworthiness of the bike, and to wear the right protection.

We believe the macro and micro fundamentals remain firmly in place. Recent growth data have been robust and in line with the broad-based improvement observed over the past six months. This includes Chinese survey data that matched the general strength even though some slowdown was expected. We have also kicked off the US earnings season in good health: with a more than half of companies having reported, 80% of firms have beaten earnings per share estimates and the same number have raised guidance. Therefore, we see no signs of disruption in global economic activity, rather a confirmation that growth fundamentals remain in place. Stock market selloffs are concerning when the real economy looks overheated. Currently, signs of excess remain quite limited.

US inflation data published on 14 February offered another test for markets. The consumer price index (CPI) beat expectations for the second month running, but investors delivered a far more muted response than we saw at the beginning of February. This was a clear sign that markets may finally have priced in the prospect of higher inflation.

Positioning portfolios

We dynamically adapt portfolios to shield our clients from increased market volatility. In this instance, we made two clear moves, favouring both convertible bonds and the Japanese yen (JPY). In November, our Investment Committee increased exposure to convertibles, which tend to do well in just such an environment. These are debt instruments which can convert to equities under certain conditions. This means they can contain the equity drawdown thanks to their bond floor, but can still benefit from much of the upside in stocks - and from the increase in market volatility which raises the probability of equity convertibility. In January, we initiated a long exposure to the JPY against the US dollar (USD) as we believe it is an undervalued currency in a confident economy and with significant upside in the case of any further strong sign of monetary policy tightening. Again, this positioned us to absorb the spikes of volatility.

As markets recovered from their mini meltdown, it was a good time to exploit our central, positive view and seek out returns for our clients. To do this, we chose to sell some puts on European stocks. This allowed us to monetise directly our expectations for a recovery, while still giving a cushion against all but the most dramatic further falls. Shortly before the correction, we had also taken profits on our USD hedges in Euro (EUR) and Swiss franc portfolios, reflecting a successful conclusion to our 2017 play on positive trends in Europe. The EUR/USD exchange rate has moved towards our long-term target of 1.25, reaching its long-run fair value.

The markets’ mettle will be tested again before the year is out. As we predicted, the normalisation of monetary policy, inflation and economic conditions will offer peaks and troughs during 2018, but in a still-benign environment, this is an opportunity which should reward the agile and vigilant investor.