There has been a lot of commentary regarding equity market volatility of late, attributing it to various factors such as trade wars, inflation, Donald Trump or even the Russians. We think the return of volatility is absolutely normal, to be expected and even embraced.
For most of history, volatility has been around current levels, and it was the last few years where it has been abnormally low. The reasons often given for the period of ultra-low volatility are things such as QE, or a very benign market environment. We think it is much more likely that the short volatility strategy, which had been both highly profitable and highly popular, had driven near term volatility down to unreasonably low levels. Essentially, ‘investors’ were selling short the VIX ETF or writing short-dated options and it had been a profitable strategy. As is often the case when the market knows something irrational is occurring, at the first sign of weakness, the market smells blood and mean reversion occurs in a dramatic and, at least for the leveraged investors, very painful way.
So, we see the return of volatility as a very healthy sign, as ultra-low volatility was disturbing and increased market risk. These more ‘normal’ conditions mean there is one less thing to worry about.
When we consider the other near term market worries, they can also seem largely overblown. The first concern was rising inflation putting a dampener on markets if bond yields spiked, however, while we do think, on balance, yields and inflation will rise over time, inflation pressures actually appear to be easing at least in the near term.
The apparent trade wars also seem to be an overblown worry. Donald Trump’s approach on many issues appears to be to tweet loudly as a negotiating tactic and then negotiate a reasonable solution. So, what has been achieved? China has agreed to reduce the barriers to some foreign firms operating in China, which will better protect intellectual property rights, while Trump has obviously won some votes from the rust belt. While Trump’s approach to these types of negotiations are clearly unconventional (being so public and blunt), we think the market will, over time, become more used to his style and less sensitive to the outbursts.
The potential for Donald Trump to be impeached or a greater scandal to develop might provide a further reason for volatility but in reality it is unlikely to affect markets over anything but the short term. It is ultimately economic and financial factors that drive financial markets, politics being important only in as much as how it impacts the economy. We hold the same view regarding the West’s recent run in with the Russians. Russia has been an increasingly hostile actor on the world stage for some time but we don’t think there is much probability that tensions will escalate to materially damaging levels as none of the parties care enough on the issues at stake. Whether around the Syrian issue, or the use of nerve agents in the UK, the Wests’ responses seem designed more to placate the media than to genuinely escalate the issues.
So, ultimately if you look through the near term noise, what do you see? Economic growth is strong, although less so possibly in Europe than before, and inflation is not accelerating to a worrying degree, which means rate rises will continue at a steady, but not uncomfortable, pace. Company earnings growth is very strong, making valuations more reasonable than previously thought and real interest rates remain very low or negative and the yield curve still slopes upwards suggesting the bond market regards the outlook as benign. Of course, this may in time change but having seen a near term correction we feel the medium term trends for strong performance of economic sensitive regions and sectors can reassert.
The value of investments will fall as well as rise and investors may not get back the original amount invested.
Forecasts are not reliable indicators of future returns.
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Source for information: Miton as at 18/04/2018 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
Miton has used all reasonable efforts to ensure the accuracy of the information contained in the communication, however some information and statistical data has been obtained from external sources. Whilst Miton believes these sources to be reliable, Miton cannot guarantee the reliability, completeness or accuracy of the content or provide a warrantee.
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