At about the same pace as the rising stock markets, volatility has come down in the past months to the record-low levels we have seen in the period 2003-2006 for the last time. Despite, or should we say due to these low volatility levels and the remarkable stability in markets and investor behaviour, more and more investors seem to wonder what the catch is. The fact that the current stability itself can contribute to future instability (basically by creating over-confidence and excessive risk-taking) is an obvious reason to have this concern.
Yet, at the same time it is clear that these periods of stability can last for months, if not years. Mostly, shifts from a low-volatility to a high-volatility regime need a trigger to materialise. These triggers do not seem that obvious to identify during this summer. There are always things that could go wrong or unexpected shocks that could materialise – nothing is more certain than that – but compared to the “hot” summers of credit crises, commodity spikes, euro crises and fiscal cliffs in recent years, the outlook for the summer of 2014 looks relatively benign.
Even so, some potential triggers can be imagined. The first one might be the summer drought in market liquidity. More than ever is low market volatility currently accompanied by low trading and liquidity levels in almost all parts of global markets – not only in credit space, but also in bond, currency and equity markets. This could indicate that an even smaller trigger or shift in investor behaviour could translate into a significant market correction, as a limited amount of investors can already have an impact on market pricing in such an environment.
Next to this, uncertainty over the outlook for monetary policy – especially in the US and the UK – might trigger more risk-averse investor behaviour. Not so much in our opinion however, as a substantial shift in actual policy setting is already in the offing for the second half of the year. Nevertheless, this topic has been – and still is – the single most influential factor for global investor sentiment. Also, the usual suspects of an oil or commodity shock (turmoil in Iraq and Ukraine, the increased possibility of “El Niño”), persistent growth disappointments in developed economies and intensifying deflation fears in Europe might become more dominant again. Given the recent history of digestion by markets of geopolitical tension and the recently further enhanced commitment of the ECB to fight off deflation these risks seem containable, but close monitoring is certainly needed.
Finally, the largest “Grey Swan” of them all, a systemic crisis in China, can’t be ignored. A sharp correction in real estate prices and construction activity, against a backdrop of fading growth momentum and a rising book of non-performing loans on bank balance sheets, create little doubt on the seriousness of this potential risk factor. However, whether it will prove to be this or next year’s problem remains impossible to predict right now. More importantly, whether it will prove to be a systemic crisis with regional implications or one with a large global fall-out is another impossibility to know in advance.
All in all, there are risks surrounding our summer outlook, but they’re not troublesome enough (yet) to adapt our near-term risk-on allocation stance. We remain overweight a broad spectrum of risky assets, with equities as our clear favourite.