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Inflation may well be still missing in action, but the last couple of days our other long-term missing companion, volatility returned to the markets. Over the past five trading days global equities were down 1.7%, real estate 2.7% and the ten-year German bond yields rose another 12 basis points to reach the highest level since end-2015. Also the USD witnessed some important intra-day moves last week on comments from politicians and policy makers.
Of course, from a longer term perspective, volatility is still relatively low (for example the average level of the VIX since 1990 is 19) but especially in equities we need to go back to August 2017 to find the VIX above current levels.
Does this mean we are on track for a long period of higher volatility? The macroenvironment of the past year(s) was characterized by a synchronized global growth and a highly accommodative monetary policy. This has created a higher degree of certainty with regards to ex ante return expectations. These elements dominated the occasional spike in market volatility caused by political developments like Brexit, key Eurozone elections or US policy making.
However, the market environment may be heading towards a new phase.
On one hand, policy accommodation will gradually be scaled back. The ECB will according to our base case fade QE between September and year end, whereas the Fed is expected to increase rates three or may be four times this year and another two times in 2019, while continuing to shrink the balance sheet. The BoJ may also adapt its yield curve control policy once underlying inflation moves above 1%. This clearly requires a mind shift for investors: from “lower for longer” towards normalization.
On the other hand, the macro outlook for the coming quarters remains solid with the synchronized growth path to continue. This could be a counterbalancing factor, keeping volatility in check.
Political developments play only a role in the background. Early March, there will be elections in Italy but it is certainly not a source of worry for markets, especially as the faith of the Eurozone is not a hot political topic in these elections. This political stability factor, as we measure it through an analysis of news and social media sources, is illustrated in the graph below.
Source: NN Investment Partners
Even in the constructive environment we are currently in, a market correction was long due given the extended level of investor positioning, strong consensus thinking and a high degree of optimism. From a technical point of view, the equity market was also moving in overbought territory.
In our investment process we take these behavioural elements into account, which has prevented us to get carried away by the consensus even in the wake of continued strong macro and corporate fundamentals.
We maintain our constructive view on the market and think that this correction and increase in volatility will create new opportunities to exploit.