More Rumination on the Low Level of Market Volatility
Axioma’s Applied Research team has been thinking (and writing) a lot about the low level of market volatility. Much of the commentary on equity markets has centered around falling correlations, whether it is between companies, industries, currencies... My colleague Christoph Schon has recently written about the changing nature of correlations between exchange rates and equity markets and their impact on volatility of multi-asset-class portfolios (see the paper on Factor Correlations Revisited). One question is whether these correlation changes are just temporary or reflect a secular shift.
As I try to get away from the facts and figures and focus more on the economics, I have developed a hypothesis: Perhaps the broader driver of low volatility is the move away from globalization in many parts of the world, particularly as exemplified by the Brexit vote and the populist-driven election of Donald Trump.
Why does this mean low volatility? As countries become more internally focused they are less dependent on what is happening next door or across the ocean – and therefore their markets are less correlated with each other. As populist policies take hold they necessarily benefit some industries more than others, and the breakdown of winners and losers may change from where it had been. Think the negative impact on technology companies that may not be able to find the necessary skill set domestically. So, industries become less correlated.
Add to that generally strong economies around the world. Asset correlations tend to be higher when there is a unifying theme driving all stocks. That theme is often a “crisis,” such as the European Debt or Global Financial crisis, but can also be general economic malaise that is likely to impact most companies in a similar way. When investors don’t have to worry about the market falling apart they can focus more on the individual merits of one company versus another and companies become less correlated.
And as central banks pursue opposing policies, after years of coordinated programs, global bond and currency markets may decouple.
Wait, you say, voters have rejected the populist wave in France and the Netherlands. German elections don’t seem to be pointing away from the status quo. So, are we really seeing a secular trend? Only time will tell. As Christoph pointed out in last week’s blog post, geopolitical tensions do seem to be driving investors to safe-haven assets. Short-horizon correlations seem to have ticked up in the US, Europe and Emerging Markets (although risk forecasts have not yet meaningfully increased). However, nothing on the near-term horizon would lead me to expect a reversal of anti-globalization moves in the US or UK (even as the rest of the world seems to be moving in the other direction, further driving down correlations).
To view more on Christoph's paper on Factor Correlations Revisited, please click here.