Where Did Volatility Go – And Where Will It Take Markets Next?

BALTIMORE, Dec. 18, 2017 /PRNewswire/ -- Volatility in equity markets has dwindled to historic lows as U.S. equity market indexes soar past record highs. Even professional market watchers are hard-pressed to definitively explain the calm.

"We are in a sort of fear/greed bounce right now," declared Mark S. Lindbloom, a fixed income portfolio manager with Western Asset Management, of Pasadena, CA. "We have a lot of greedy chickens in the market; people don't want to give up the upside. We are in the ninth inning of a baseball game. That ninth inning can last a long time, but everybody is very concerned. They are afraid things are too good, volatility is too low. That's why they are moving more into high-sustainable-dividend stocks, or lower volatility stocks, as a hedge, to stay in the equity markets."

"I think absolutely it's time to rotate into things that are a little more defensive. But investors are afraid to not be in the market because they are afraid they will miss another 20 percent up."

If volatility does take a turn, Jeff Schulze, an investment strategist with ClearBridge Investments, suggested it could bring turbulence in 2018 but not necessarily lead markets to hard landings.

"Volatility should pick up here from here," Mr. Schulze predicted. "We are at generational lows as far as market volatility is concerned, so the path from here is probably up. Volatility has been low because of the backdrop we have. Volatility usually heightens around recessions, yet in our opinion, recessionary risk is very low. ClearBridge put together a recession dashboard of 11 indicators that typically foreshadow an upcoming downturn. Only one of those indicators is flashing a warning sign, so we think the odds of a recession right now are extremely low."

To James Norman, President of QS Investors, diversification outside the U.S. is critical:

"The safest thing is to diversify across asset classes into different types of risk assets. Maybe hedge some of downside risks with more defensive types of assets, such as defensive equities."

"It is hard to predict whether emerging markets, or international markets outside of the U.S. on the developed side, or stocks in the U.S., are going to outperform," he said. "Investors should diversify. The growth potential outside the U.S. is probably higher. EMs and international developed markets are probably about five years behind the U.S., which is reflected in valuations and the growth cycle. Those markets could be very attractive over the next one to three years."

"There is nothing obviously cheap," Mr. Norman emphasized. "Central banks encouraged investment in risk assets by keeping interest rates so low, and that's why valuations have risen. It is hard to predict when a market drop will occur. It is important to keep invested in risk assets, whether it's credit spreads, equities in the U.S., international developed, or emerging markets. There are just so many opportunities. This might go on for a while, and it might not."

Mr. Lindbloom also said Western Asset is recommending selected emerging markets to clients.

"In the cycle we are in, with the underperformance in previous years, very select emerging market bonds – in U.S. dollars as well as local debt and currencies – are quite attractive."

Mr. Schulze keyed on earnings growth, which "has beat to the upside for the last three quarters."

"That's going to continue into 2018," he forecast. "Global central banks are tightening, but not enough to choke off the economy. That all coalesces into a backdrop of low volatility. Share buybacks are at the high end; that's also a volatility dampener, forward guidance. All these things are just pricing in volatility lower, because there should not be a lot of fear in the markets."

About other opportunities for global bond investors, Mr. Lindbloom was cautiously optimistic.

"We are certainly seeing a continued inflow," he said. "A lot of cash is still finding its way into the U.S., particularly from Asia, Europe and other parts of the world. When that stops will be an important factor in how we position. It's easier these days in the fixed income world to identify those sectors we don't like: for example, $8-10 trillion of sovereign debt trades at negative interest rates. High yield in Europe trades at 2 percent, a bit higher adjusted for currency."

"There are pockets we like. We have been much more selective late this year, into 2018, on investment-grade cooperates, sticking with sectors that are deleveraging and not piling on debt, like banks, energy, minerals and mining. We avoid those that continue to leverage up in high yield. We have been moving up in terms of quality because we are concerned about leverage."

Having traveled around the country, Mr. Schulze said he has met with investors from many regions, often with very different levels of sophistication, to broadly gauge market sentiment.

"There is a lot of skepticism out there," he reported. "Investors are really scared that we're close to the abyss, and there is a big drop ahead of us. That's not behavior you see at the end of a bull market. It's head-scratching that, in the ninth year of this expansion, you still have so much fear."

"I think there is still room to go on the upside, just from a sentiment perspective."

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