Poor politics

These negatives are tempered somewhat by the ongoing hope of progress on at least one big-ticket item, notably tax reform; however, at this stage there is little tangible progress to see.

The North Korean tensions that were so prominent two weeks ago have not gone away, but have moved a bit more to the background. While the eventual outcome remains an open question, the fact that the situation has not immediately deteriorated further has been enough for risk appetite to recover and markets to regain their footing.

Indeed after the short-lived spikes in market volatility last week, we have seen these measures decline back to the average level of the last year. Whether this is justified or not is debatable, however what is not in question is that the selling of volatility has become an increasingly popular strategy. These strategies take positions that benefit from an ongoing decline in equity volatility but are very susceptible to sudden spikes, like the ones we witnessed over the last two weeks.

Nevertheless even after suffering a peak-to-trough loss of 25%, in the space of two weeks, investors in ETF’s that follow this strategy doubled down with new inflows taking the assets invested to a new record for the year.

This type of behaviour makes sense for as long as you believe the current market environment we are experiencing is the one that will continue to prevail. Extended periods of low volatility are more the exception rather than the norm, with the last comparable period being in 2004-2006, and while they tend not to last, perhaps “this time is different”.

There are a few contributors to the low volatility environment, with confidence in the growth outlook, and confidence that central banks will maintain accommodative monetary policies, two of the most important ones. We will get some additional information on the second of these this week, with the upcoming Jackson Hole conference. Given that the theme of this year’s event is “Fostering a Dynamic Global Economy”, we should probably not be expecting anything from Fed Chair Yellen or ECB President Draghi that will upset markets too greatly.

Nevertheless we note that markets are already priced for a continuation of very dovish policy from central banks even as the growth picture continues to. Moreover, there is always the possibility that comments can be misinterpreted or cause investors to re-assess their thinking. While our fundamental and behavioural data support a move to a slightly more positive stance on government bonds, relative to recent weeks, we hold onto our medium underweight in Treasuries ahead of the event.