After falling to a 50-year low volatility could return with a vengeance if reality deviates from market expectations in the year ahead, a new paper from multi-affiliate funds management firm Legg Mason says.
“A prolonged period of low volatility can also act to increase the scale of volatility once it returns,” the ‘Legg Mason 2018 Outlook’ says.
The report cites data from affiliate global equity manager, Martin Currie, showing volatility at “50+ year” lows that have skewed many portfolio risk models based on short-term trends.
“As a result, many may now be ‘increasingly underestimating the true level of risk in portfolios’, according to Martin Currie,” the Legg Mason report says. “A pick up in volatility could, therefore, lead to a more rapid market response as risk models adjust from their low base.”
With most investors also banking on continuing market performance and a “benign” economic backdrop, any disappointment could trigger an “outsized movement in asset prices”, Legg Mason says.
If it does reappear volatility would likely surface first in fixed income markets, the report says, transmitting perhaps 30 months later to equity markets based on historical trends mapped by another Legg Mason partner firm, ClearBridge Investments.
According to Clearbridge, the winding down of central bank crisis-mode policies could inflame smouldering markets.
“In [Clearbridge’s] view, while quantitative easing acted as a pacifier of volatility, quantitative tightening may act as an accelerant,” Legg Mason says.
The paper says the current era of repressed volatility has been attributed to a number of factors including:
- The growth of index-based investment vehicles at the expense of investing in individual securities, possibly hampering the markets’ ability to offer meaningful prices for individual index components;
- A general move away from traditional asset classes in favor of alternative investments, such as real estate;
- Increased regulation, the result of the 2007-8 global financial crisis; and,
- An increase in the ability of financial markets to take potential future fundamental and economic factors into account in current prices.
“None of these explanations have convinced investors to put their worries aside. Investors looking to control their portfolios’ risk profile have been focusing on volatility at least as much as on high valuation in today’s markets…,” Legg Mason says.
“So whilst we do not believe the current environment demands an overly defensive posture from investors, it would be a mistake to be entirely complacent. The key is to have strategies in place to deal with a potential increase in market volatility in order to be better protected in an uncertain future.”
Legg Mason Global Asset Management represents nine affiliate firms with fixed income specialist, Brandywine, best-known to NZ investors.