Oliver's Insights

KEY POINTS

• Equity market volatility has fallen in the past two years.
• This reflects the relatively stable macro economic backdrop. It is not unusual in a long-term context.
• We expect volatility to rise this year.

The decline in sharemarket volatility
Sharemarket volatility has fallen over the past couple of years. The last time we had a 15%-plus correction in major sharemarkets was in 2002-03. The decline in volatility is evident in the charts below, which show a measure of the volatility of monthly returns (their standard deviation) over rolling 12-month periods for the US (first chart), Japan, Europe and Australia.

The US VIX index of implied option volatility has also fallen, indicating investors are pricing equity options on the assumption volatility will remain low.

This begs the question as to whether the low level of volatility over the past few years is sustainable or not? Sharemarket bears have been saying for the past two years that volatility will soon rise and that this will be bad for shares. But before looking at this, it is useful to look at what drives volatility and to put its recent decline into a longer-term context.

What determines volatility? Investment market volatility is essentially determined by:

• new information that surprises the market, such as unexpected bad earnings news or a change in interest rates; and
• the extent to which the market is vulnerable to surprise; for example, if investors were fully invested in shares then any bad news could result in sharp falls, but if they only have modest exposures then there would likely be less selling pressure.

Long-term drivers '” less surprise, more vulnerability
The last century has seen a decline in the surprise driver of volatility. Economic fundamentals such as economic growth and inflation are now far less volatile.

This decline in economic volatility has been driven by a combination of factors including: the growing importance of the relatively stable services sector; improved inventory control; reduced capital spending lead times; globalisation; and improved economic management by central banks.

This should have resulted in a decline in sharemarket volatility but it hasn’t. The chart below shows volatility for Australian and US shares going back to 1900. Abstracting from the Great Depression and World War Two period and the high-inflation 1970s and 1980s (especially in Australia), current volatility is low but not out of line in a long-term context. See the next chart.

There is no evidence of any long term decline in volatility in the US. This may reflect several considerations, including little long-term decline in the volatility of corporate earnings and the market may have become more vulnerable to any surprises due to higher levels of leverage, more correlated bets (more investors having similar positions), shorter holding periods for shares and a greater focus on momentum trading. There may now be a huge volume of more accessible information today, but if investors all get it at the same time from their screens and have similar positions then they are more likely to change their positions at the same time – resulting in additional volatility even though the external drivers of volatility are less significant.

In Australia there is evidence of a secular decline in volatility since the 1970s and 1980s and this likely reflects a return to more normal economic conditions after the economic turmoil of those decades, along with the reduced importance of the relatively volatile resources sector.

Short-term drivers – the economic and investment cycles
The short-term cycle in volatility largely reflects the economic and investment cycle.

• Volatility tends to rise during the boom, bust and then initial recovery phases in the business cycle '” just before, during and immediately after economic downturns. This tends to be when economic surprises '” both good and bad '” are at their greatest, and is often magnified in terms of their impact by high levels of corporate debt. It is also when sharemarkets tend to become most mis-valued and when investors take extreme positions, such as being very bullish on shares (and hence vulnerable to bad news) towards the tail end of an economic expansion, or very bearish (and hence vulnerable to good news) during recessions. This explains why sharemarket volatility increased during the 1998–2003 period.
• Volatility tends to fall and stay low during the mid-cycle phase of the business cycle as this is when the economy is most stable and arguably predictable, corporate debt is low, shares are not at extreme valuations and investor positioning is not extreme

Over the past two years we have been in the mid-cycle phase and this explains why volatility has been relatively low. Economic growth has generally been reasonable. The bad news on oil prices has been offset by continued good news on profits, both in Australia and globally. Sharemarkets have not been overvalued. And investors have repositioned towards shares (after cutting
back exposures during the bear market years) but have not had extreme positions.

So where to from here for volatility?
Our assessment is that volatility will gradually edge higher over the next year:

• corporate borrowing is starting to rise in the US and Australia and this will eventually lead to greater earnings volatility;
• corporate profit growth is slowing and actual earnings results are less likely to surprise on the upside so good news on profits will be less able to offset any bad news on oil prices or inflation; and
• as investors’ exposure to shares rises this is making them more vulnerable to any bad news. This increased vulnerability started to become evident in Australia last year with two corrections of about 8% each (around April and October) and is also evident in the recent gyrations in Japanese shares.

In fact, as the second chart indicated, volatility in the European, Japanese and Australian sharemarkets has already started to edge up.

The good news, though, is that investors do not appear to have become overly complacent yet '” equity valuations have not been pushed to overvalued extremes but remain at reasonable levels. Similarly, a big increase in macro economic volatility is unlikely; inflation remains relatively benign and interest rate increases around the world remain moderate (characterised by a return to normality rather than excessive tightening). So we don’t expect a severe increase in volatility as would be associated with a major
bear market in shares.

In this regard it should be noted that rising volatility is not necessarily associated with the immediate onset of a bear market. From 1996 to 1999 US sharemarket volatility rose (see the first chart) with 10% plus corrections every year (including a 22% plunge in 1998) but all in the context of very strong equity returns.

So the most likely scenario is that, in the absence of any impending recession or overly aggressive rise in interest
rates or some other external shock, sharemarket volatility will gradually pick up. But since valuations and earnings growth are still reasonable sharemarket returns are likely to remain solid. For Australian (and global) shares, investors should anticipate a correction of about 15% during the course of this year, most probably in the second half, within the context of the rising trend in share prices.

Conclusion
Rising corporate borrowing, slowing profit growth and increasing investor exposure to shares suggest that sharemarket volatility will gradually move higher over the next year.