Markets & Economy
It’s Quiet Out There…Too QuietApril 19, 2017
- While investors continue to enjoy positive returns from global equities, one nagging source of discomfort is the remarkably low levels of volatility being displayed by markets, especially given the uncertainties that remain ahead.
- Falling volatility is in part a reflection of some positive changes in the global economy. Corporate profits have also been steadily recovering, while interest rates remain low and monetary policy accommodative.
- However, there has been an element of hope and sentiment that has played its own role in lifting markets as consensus has shifted quickly from despair to exuberance in the space of a year.
- While the market continues to look to politics and macro data as sources of renewed hope, now is the time to get stock specific and to refresh your portfolio should any disappointments happen.
While investors continue to enjoy strong returns from global equities, one nagging source of discomfort is the remarkably low level of volatility being displayed by markets, especially given the uncertainties that remain ahead on the macroeconomic, political, and corporate earnings front. This perspective is demonstrated by the MSCI All Country World Index returning 7% for the year to date and over 10% since the U.S. election,1 with resolute and largely uninterrupted upward momentum. The calm nature of markets can be evidenced by realized equity market volatility falling to levels rarely seen in recent market history (see Figure 1).
While more return for less volatility is always a welcome perspective for investors, it’s rarely a sustainable backdrop at such extremes.
So why has volatility been falling? It’s important to note that falling volatility is in part a reflection of some very positive and real change in the global economic environment. Improving data include an increase in the global purchasing managers’ index, which—after first turning upward in the summer of 2016—is now reaching levels consistent with a solid acceleration in global economic growth. Corporate profits (actual and expected) have also been steadily recovering from the depths in a period where it has become crucial for companies to deliver their own individual improvement, given rising expectations that are quickly being reflected in many stock valuations. Meanwhile, global interest rates remain low and monetary policy remains accommodative. So far, so good, so why are we looking for reasons to be more cautious than consensus near term?
Despite the fundamental improvement, hope and sentiment have played their own role in lifting markets as consensus has shifted from despair to exuberence in the space of a year. This is very apparent when looking at the dramatic shift in U.S. smaller business sentiment since the election (see Figure 2, left chart, with the contrasting perspective of economists on the right). This positive shift in sentiment feels somewhat mirrored in equity markets and has its roots in improving data as well as the potential impact that U.S. policy change may have upon U.S. and global economic growth prospects, despite a lack of concrete policy proposals from the Trump administration. The implication such an acceleration has for cyclical segments of the global equity market has caused a wave of cyclical buying in the postelection period, a trend we are leaning against with a carefully contrarian stance.
Tax reform/cuts, fiscal stimulus, and deregulation certainly have a growth-centered foundation as Donald Trump seeks to implement policy to back his preelection rhetoric. We remain cautious on the real impact of policy, however, especially with respect to high-level macroeconomic conclusions that in reality are unlikely to be borne equally across industries and sectors.
In many respects, while the market continues to look skyward to politics and macro data as sources of renewed hope, we believe that now is the time to get stock specific and to refresh the wish list of stocks that may be coming on sale soon, should any disappointment on macro or political dimensions arise. On this point, while the volatility of the market is optically low, the volatility across sectors (cyclicals versus defensives), style (value versus growth), and on many singular stock bases feels above average. This is an unusual perspective and has certainly created more volatility in alpha for active investors (ourselves and our competitors alike), despite the relatively low level of volatility in equity market beta.
So what are the risks to the low-volatility environment ending, and what are the implications for equity markets? While recent data have been positive in almost all respects, this is partly the risk facing stocks. Following years of stop/start, fear/relief cycles since the global financial crisis, we find ourselves at a point when the data are setting up a positive reference point in these “good” times that invariably becomes hard to exceed. While as fundamental investors we enjoy good news on the fundamental front, it is likely that we will see the momentum in economic activity fade at some point, while our best estimate is that positivity around U.S. policy is likely to miss a step at some stage. Either scenario will give renewed fuel to equity market bears that have been temporarily silenced (or quietened at least). However, it’s important to note that, all else equal, we would remain buyers of our favored stocks upon any such weakness. Applying the courage of your convictions during times of pessimism has been crucial during this now very long and mostly bumpy bull market. We do not believe this perspective has changed.
Aside from sentiment and economic improvement peaking near term, we are also conscious that inflation (most notably in the U.S.) is rising once more and creating some medium-term risks to the equity market cycle. At this point in time, higher inflation is being seen as a reflection of the economic improvement that began nearly a year ago. However, embedded in rising U.S. core inflation is a growing wage inflation trend that has consequences for corporate profit margins that are already backing away from peaks reached in 2015. Pricing power for individual companies is, therefore, going to be an important feature of the haves and have nots in terms of defending margins and growing profits in the next stage of the equity cycle. So, too, will debt serviceability and leverage, if U.S. interest rates follow a path of modest increases as we expect.
Medium term, the dispersion of corporate earnings as companies monetize their opportunities or disappoint in a new regime of raised expectations and raised valuations is likely to move equity market volatility upward to more “normal” levels. This shouldn’t be seen as a sign that the equity cycle is ending, but more so that a period of unusually positive data and sentiment is normalizing, creating renewed entry points for both the near-term cautious and the long-term contrarian.
1As of March 31, 2017. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of April 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.
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