Too Much Complacency

by | Jul 22, 2014

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Yes, if you thought things were getting a little too cosy for comfort on the volatility front recently, it turns out that you’re not alone. After a six-month of near record lows on the Vix volatility index, we’re now looking at a return to business as usual.

That, at least, seems to be the message from Russ Koesterich, BlackRock’s Global Chief Investment Strategist, who has been putting a bit of a damper on the summer party season with today’s pronouncement. But is he right? At a time when so many markets are struggling to defend their January levels, it’s probably safer not to ignore the Jeremiahs.

Consequences of Complacency

“Thursday’s sell-off was significant in at least one way,” Koesterich begins: “It was the first time since April 16 that the S&P 500 moved more than 1% in a day. The three-month streak had not been equalled since 1995.”

“While the spike in volatility was short lived, it was the first time investors have been shaken out of their complacency since April. And as the uptick is coming from historically low levels — the bottom 1% of historical observations — it may have much further to go. Even at its peak on Thursday, equity market volatility, as measured by the VIX Index, only reached 15, roughly 25% below the long-term average.”

“Low volatility suggests that investors are complacent and not taking into account the prospect for bad news. Indeed, there is no shortage of potential triggers for more turbulence ahead.”

 What sorts of triggers? Need you ask? The downed airliner in Ukraine, the continued fragmentation of Iraq, and now a ground war between Israel and Hamas in Gaza.

But, Koesterich warns, investors should also be mindful of conditions in credit markets. “One of the major reasons volatility has been suppressed is linked to the unusually accommodative monetary policy of the Federal Reserve and a very benign credit cycle. Should the Fed raise interest rates sooner than expected and foster a less accommodative regime, that would likely be associated with a further rise in volatility.”

Okay, that’s taking us into more interpretative territory, but it’s hard to disagree that Fed chairman Janet Yellen’s recent teasing (oops, sorry, ‘forward guidance’) about interest rate policy in the States has the potential to turn nasty. Central bankers don’t generally let the world know in advance exactly then they’re going to move, of course – it would rather spoil the point of the exercise – but nevertheless, there do seem to be enough arrows pointing in the same direction at the moment to merit some caution.

How Should an Investor Respond?

On this, at least, Mr Koesterich seems to be in predictable territory. Rebalance in favour of asset classes that will provide some cushion, primarily vis-à-vis less challenging valuations -in particular, an equity mix geared toward U.S. large caps (he’s talking mainly to a US audience, of course), and particularly in energy and “old tech” – while carefully avoiding the momentum names in social media.

Take heed of “more speculative sectors that look even more expensive, such as biotech”, he says. And reduce exposure to retailers and consumer discretionary companies, which he says are also expensive, trading at nearly a 25% premium to the broader market. But there are some surprises in the mix.

 Not least, an increase in international exposure, particularly in Asia. The recent improvement in Chinese economic data, says Koesterich, has “provoked the beginning of a rotation back into emerging markets (EMs). Last week was the sixth consecutive week of inflows into EMs, which suggests sentiment toward the asset class is starting to turn.”

 And, of course, “Hope for the best, prepare for the worst.” For investors, says Koesterich, “that means emphasizing asset classes and regions that offer some relative value, and that can help mitigate the impact of a market correction.”

 

 

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