The pricing in of higher volatility: good or bad?
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|ETF Investment Strategist|
Members of the Federal Reserve (Fed) have been increasingly explicit on the risk of low interest rates leading to financial instability over recent months. US Fed Chairman, Jerome Powell, stated: “raising interest rates too slowly may lead to high inflation or financial market excesses” in his semi-annual testimony before Congress earlier this month.
One gauge of market risk is volatility in asset prices. Should volatility be a source of concern for investors? We believe so most notably for equity investors, as there is a long-term negative relationship between volatility and equity valuations, as illustrated below:
Past performance is not a guide to future performance.
What did investors learn from 2008...?
Beyond short-term events, the last two years have been characterised by low market volatility, low interest rates, and economic expansion in the US. This stable environment has fuelled an increased appetite for risk among investors, who have either lowered the quality of their holdings or increased financial leverage.
Those with financial leverage are the most vulnerable to an unexpected increase in interest rates and can spur a significant market correction if the cost of borrowing suddenly exceeds the returns of investments. An increase in leverage and a rise in equity valuations in response to low interest rates is known as a “Minsky cycle”. This theory relates to the fact that a sudden spike in volatility could derail this fragile environment, leading to a sharp market correction and financial instability.
We think that the February sell-off may have been a ‘mini Minsky’ moment but that any subsequent market corrections should be relatively short lived and limited in magnitude.
The reasons being that:
- the gradual and well-telegraphed normalisation of monetary policy in the US limits the risk of an interest rate shock, and
- the current market pricing of future volatility suggests market participants already anticipate higher volatility in the near term.
… Stability breeds increased risk
While volatility has declined from its February highs, it is higher than in 2017 but low by historical standards, which has prompted questions about market complacency.
We believe that the level of realised volatility is less important as an indicator of market complacency than market expectations of future implied volatility. The latter reflects how investors are pricing risk in the short to medium term. A combination of factors, such as geopolitical risks, the maturing economic cycle, and rising global interest rates, have led market participants to price in higher volatility over the next two years. Currently, investors expect volatility to increase relatively rapidly over the next twelve months and converge towards its historical average level (around 15%).
The graph below compares current volatility expectations to the volatility in the period before the last financial crisis. Because investors are anticipating that volatility is bound to increase in the medium term, any surprise should be brief and limited. The eventual impact on financial stability from a shock of volatility should therefore be less than it was in 2007.
Past performance is not a guide to future performance.
The gradual rise of interest rates alongside market volatility suggests a relatively orderly downturn in the medium term rather than a market crash. We believe this market outlook makes the case for a gradual rotation towards defensive equity strategies rather than an immediate rush to safe haven assets.
Balancing upside potential with immediate additional income
One way of achieving higher income with comparatively low risk is through a covered call strategy. The BMO Enhanced Income strategy is implemented by selling (writing) index call options against part of our equity portfolio, which replicates one of the regional stock indices (US, UK and eurozone). By writing call options against an equity index, we forfeit some potential upside participation in exchange for an immediate additional cash flow over and above what would be received by simply holding the stock. Approximately half of the portfolio serves as collateral for the option writing strategy, and the other half fully replicates the underlying index.
The strategy is most likely to outperform in bearish, non-directional and slightly rising markets. Conversely, the strategy underperforms in a strong market rally. Over the long-term, the strategy provides equity market exposure with greater income and lower volatility.
Comparatively low-risk approach
The key risk of the strategy is the possibility of being forced to sell the stocks that serve as collateral when the underlying stock market is rallying, as it may lead to an underperformance versus the benchmark index. However, this represents an opportunity cost rather than a loss. If the call options are exercised, investors will still profit but will not fully participate in the underlying market rally.
A covered call writing strategy also means that investors will not be exposed to the full impact of market downturns. The premium received from writing the call options acts as a buffer when markets are falling, meaning that the strategy will generally outperform the market.
Our strategy is likely to benefit further in the coming years as higher volatility implies that writing covered calls will become more lucrative from increased premiums. If the volatility level settles at its long-term average, the annualised option yield will gradually increase from a target of 2% per annum in the previous low volatility (10%) environment, to around 3% per annum in the UK, US and Europe.
 This notion was first stated by Paul McCulley of Pimco in 1998 in reference to the US economist of financial crises Hyman Minsky, and relates to the observation that stability (i.e. low volatility) can lead to financial instability.
 This echoes similar findings from the NY Federal Reserve (“The Low Volatility Puzzle: Is this time different?”, 15 November 2017, Liberty Street Economics)