Are low volatility readings capturing a sense of calm or foreboding?

Last Friday, the Vix – often referred to as the “fear gauge” – declined 6.6% in a single day to close the week at 10.1. We haven’t seen that kind of low for the past decade. In fact, I even searched the “MAX history” in vain, failing to find anything that came close! In Japan, the JNIV – the Vix equivalent for the Nikkei 225 – fell to 14.81. Again, you’d have to look more than 10 years back to find a similar occurrence (my chart only goes back 10 years). While the VStoxx in Europe isn’t exactly at an all-time low (last week closed at 17.05 – higher than the 15.27 level in January 2014), you’d have to go back to January 2007 to find comparable levels. Given Brexit, the ongoing French presidential and legislative election narrative as well as the upcoming UK and German elections, it is understandable that Europe’s volatility gauge hasn’t quite hit historic lows; however, given the circumstances, any reading below 20% is pretty good!

Meanwhile, front pages around the world tell of rising US interest rates, Trump’s latest contradiction (this week it was breaking up big Wall Street banks, a group previously thought to be one of the biggest benefactors of Trump’s anti-regulation stance), a possible path to victory for the biggest EU skeptic in all of France, deteriorating relationships with Turkey (which could have serious immigration and security implications for western Europe), foiled terrorism plots in London and elsewhere, and a stalled Abenomics program nearly out of steam in Japan. All the while, Brexit negotiations (on hold until the end of the French legislative series) as well as UK and German elections play out in the background. Then, to spice things up even more, there’s North Korea.

Any one of these geopolitical events has the potential to completely change investors’ outlook on the future direction of markets. Yet, all major fear gauges are at or near historic low. What gives? How do we square that circle of rising uncertainty and falling volatility forecasts? Declining volumes may provide an answer (see chart 26 in our Equity Risk Monitors for the US, Japan, and Global Developed Markets).

Market participants can be divided into two groups: the risk-tolerant, and the risk-averse. Risk-tolerant investors believe in the mantra that markets are always filled with opportunity and risk. Geopolitical events only heighten the extremes of both. Plunged straight into the deep end of the risk pool at a moment’s notice, some will always profit spectacularly. To them, the risk of failure is precisely what gives value to success. Their refusal to sell in the face of current geopolitical risk requires not only bravery, but holding power, a strong measure of risk tolerance and a willingness to trust in one’s own luck. The risk-tolerant strategy counts on one of these risk events forcing risk-averse investors to jump out of the market and accept a large discount as the exit price.

Risk-averse investors will always seek a profit, but not if it is likely to cost them. They are not gamblers. Although, given their need for yield, they prefer equity over cash. But understand this: when faced with a choice between the probability of losses or cash, they will choose cash. It doesn’t matter that they are sitting on tidy profits after the Trump and Macron rallies, all that matters to them is the possibility that it could all come to a fiery end. 

Like a swarm of bees, the noise from geopolitical risk grows in volume with each passing day, unseen but omnipresent, a danger, but not yet dangerous. History teaches us that patience is an investor’s greatest virtue and that haste can be an expensive mistress. There is, however, no ignoring the rising uncertainty that surrounds us. To do so is at best naïve and at worst negligent.

So, while newspaper headlines exclaim that geopolitical risk is rising at a velocity that can only imply panic, low correlation and volatility readings say otherwise. For now, the decline in average daily volumes on major markets suggest that both types of investors are mostly content to watch political leaders for signs of things to come (or in a few cases, evidence of some childhood disease unfortunately survived) yet aren’t really sure what they should (or shouldn’t) do next – embrace the future or fear it? Currently, investors look like a school of plump trout tempted by a dangling worm. But beware. Somewhere below the low volatility forecast lays a barbed hook. You will know fear is back in the driver’s seat when correlation spreads its tentacles across markets. It is, after all, the tie that binds both types of investors, a tie that becomes a snare when circumstances require it.

Olivier d'Assier

Olivier d'Assier is Head of Applied Research, APAC, for Axioma and is responsible for generating unique regional insights into risk trends by leveraging and analyzing Axioma's vast data on market and portfolio risk. d'Assier's research helps clients and prospects better understand and adapt to the evolving risk environment in Asia Pacific.