Dip in volatility stirs warnings about too much complacency

Global money managers and analysts are split on whether markets and investors are becoming complacent and disconnected from potential sources of market volatility, as the Chicago Board Options Exchange Volatility index — the VIX — dips to decade-low levels and leverage in credit markets creeps higher.

The VIX closed at 11.19 on July 7, as Pensions & Investments was going to press. The 52-week range is between 9.37 and 23.01. The index measures the implied volatility of Standard & Poor's 500 index options, showing expected market volatility over a 30-day period.

Some money managers are becoming concerned that markets are complacent against a macroeconomic backdrop that should perhaps be leading to more caution.

"The VIX index, also known as the fear gauge, has touched new lows" recently, said Keith Wade, London-based chief economist at Schroders PLC. "This is particularly surprising given the Fed has just raised rates for the second time this year and is also signaling another increase in September. This is even before considering China, the oil price and the rise of populism, which albeit seems to have waned in Europe for the moment."

The concern stretches across the Atlantic. "Markets are strangely complacent given the number of potential pivots facing the world and the fact that there is empirically a great deal of uncertainty in the world," said Eric Lascelles, chief economist at RBC Global Asset Management Inc. in Toronto. "This can be quantified via higher-than-normal policy uncertainty indices, as an example. The disconnect is not ideal."

Some managers also raised concerns over complacency in credit markets.

"We do think markets and investors are complacent in certain areas of the credit market like CCC-rated bonds or emerging market corporate bonds," said Victor Verberk, Rotterdam, Netherlands-based co-head of Robeco's credit team. "Investors have been taking on more risk, which is also illustrated by the huge flows into credits over the last years, often from tourist investors," described by Mr. Verberk as investors moving outside their core regions and mandates in the search for yield.

"Low rates have pushed these investors into higher yielding, risky assets" and credit valuations "have become more expensive and are no longer pricing in fundamentals at a time when the credit cycle is quite advanced and global imbalances are growing," he said.

But others are not so sure there is much complacency.

'Ongoing phenomenon'

"There is an ongoing phenomenon of leverage creeping higher, covenants getting weaker and defaults staying low," said Timothy Smith, head of fixed income at Stamford Associates Ltd. in London. "This appears to be largely facilitated by low yields which translate into relatively high levels of fixed charge coverage."

In contrast to the period from 2005 to 2008 when leverage was similarly high, Mr. Smith said the level of fixed charge coverage was "significantly below where it is today." Were new-issue spreads to widen, interest rates to rise or cash-flow generation to materially dip, this could all change, he said.

However, "from my seat I do not encounter a material degree of complacency from market participants. Most who are actively involved with credit investing have their eyes open to the asymmetries and risks within the market at this juncture and are allocated to the asset class as it represents a potentially safer option than others currently available. Whilst there might be complacent investors in the market, it does not appear to be an endemic issue," he said.

Jonathan M. Duensing, senior portfolio manager, director at Amundi Pioneer Asset Management in Durham, N.C., said his firm sees the VIX as a measure of confidence rather than complacency.

The Merrill Lynch Option Volatility Estimate index — a measure of U.S. Treasury yields not unlike the VIX — is showing a similar pattern to the VIX, he said, adding: "The low readings signal a certain level of confidence in where prices are going over the near term. Currently, the expected range for future values is very narrow."

Mr. Duensing agreed that some regard a low level of volatility "as meaning investors are getting complacent — there is certainly an argument for that. But it is also correct that investors may be placing a higher level of confidence on what asset prices will do in the near term."

That view was reinforced by Andrea Cicione, head of strategy at TS Lombard in London. "We like to think that implied volatility is forward-looking, and of course it is, but the starting point from which investors try to forecast the future is nevertheless what happened in the past. While this may seem mundane, it works well in real life."

He added: "So markets are indeed forward-looking, but they normally need a specific event or risk to focus on before they actively start pricing in a change in volatility dynamics. Until then, the anchor is backward-looking, realized volatility."

External factors

While managers might disagree on whether investors and markets are complacent, they do agree that external factors are feeding into the lower levels of the VIX.

"The reality is the elements that have depressed volatility are largely in place, and haven't really broken up," said Paul Price, global head of distribution for Morgan Stanley (MS) Investment Management Ltd. He said while you'd expect volatility to increase before a market cycle ends, volatility remains depressed for a number of reasons: "correlation of both stocks and bonds is high. We're going to continue to see interest rates rise from a Fed perspective, but the correlation effect is not appearing to break up yet in a meaningful way. We're in a pretty benign part of the curve."

J.P. Morgan Asset Management (JPM) is "reasonably comfortable with volatility being low" because of clear efforts by the U.S. Federal Reserve "to be more communicative about monetary policy," said John Bilton, London-based global head of multi-asset strategy at the firm. "We think that they were somewhat surprised by the market impact of the 2013 tapering announcement, and want to avoid a repeat of that bout of market volatility. Although the economy is moving forward, with global risks falling, one of the biggest tail risks would be the Fed being overly zealous or disruptive in raising interest rates; they want to do it in an orderly fashion," he said.

Managers agreed central bank policy is playing a big part in dampening the VIX, "with central banks acting as guarantors against risk in the market," said Mr. Price.

Added Schroders' Mr. Wade: "Central bank asset purchases are likely to continue to increase in the eurozone throughout 2018 and in Japan for longer. And it is this dynamic which is making it difficult for investors to shrug off complacency as liquidity continues to drive markets."

"We can partly blame the central bankers and accommodative monetary policy for low realized volatility," agreed Daniel Morris, London-based senior investment strategist at BNP Paribas Asset Management. "And the degree that (quantitative easing) is slowly unwinding suggests average volatility should rise."

Worried about the unexpected

MSIM's Mr. Price said the breakup of this element of support "could be one of the catalysts to see the VIX begin to move into more normalized territory."

And some managers are worried about a sudden, unexpected event having an outsize impact on confident markets. "Markets can be complacent for years but then suddenly correct sharply as imbalances burst. Expect the unexpected. What the exact trigger will be is difficult to predict. Corporate leverage is rising everywhere, increasing the sensitivity of credit markets to unexpected risks that could come from China, weak commodity markets, a more aggressive Fed hiking cycle, geopolitical or unexpected macro events," warned Robeco's Mr. Verberk.

And that's been seen in recent weeks, added Mr. Morris. "One thing you can sense in the markets with volatility low and valuations high — and it's true for equities and bonds — is when you do get a spike in volatility you find the market maybe overreact a bit in the short term. (Recent) comments (from Mark Carney, Bank of England governor, and Mario Draghi, president of the European Central Bank), although nothing new or surprising, saw a 10-basis-point to 15-basis-point move in bund and (European government bond) yields. Because volatility is so low, when there is a spike (we get a) disproportionately high reaction in markets. I am worried from that respect​ — if there is a surprise, markets may react a bit more than is warranted."