Some fear too much growth, others too little. In either case, the markets' increased volatility should be manageable.
In retrospect, 2017 would have been an almost perfect year for relying on the autopilot. But in 2018, investors have to be wide awake: focused on the road, with both hands on the wheel and prepared to change direction and speed at a moment's notice.
Although only in its early stages, 2018 has already put an end to last year's serenity. On February 8, after more than 400 days, the S&P 500 ended its longest stretch to date without a 5% correction. What's more, the U.S. stock index has already experienced 20 fluctuations of more than 1.0% year to date, two-and-a-half times as many as during the entirety of 2017. And the Vix, which represents the implied volatility of the S&P 500, registered its biggest single-day increase ever on February 5, both in percentage and absolute terms. In 2017, the Vix remained below 10 for 55 days, which is indeed remarkable given that it had only spent 10 days below the 10 level from its introduction in June 1990 until the end of 2016.
The first doomsday scenarios began to circulate when the S&P 500 slid below its beginning-of-the-year level for the first time on February 5. Since then, most markets have hovered around their end-2017 levels, with increased volatility. If high volatility is defined as being above a threshold of 20 points in the Vix, the high-volatility period in January and February lasted for 21 trading days. The next phase of wild market swings began on March 22. According to this definition, 2017 did not experience a single day of high volatility (see chart). Investors have to look back to the beginning of 2016 to find a longer period of higher volatility.
Our market forecast...
What will happen next? Volatility seems to have bottomed in 2017. The current interest-rate cycle and signs that the major central banks (Eurozone, Japan, United States) may start to reduce their balance sheets (by the fourth quarter of this year at the latest) can no longer be ignored by markets. We have identified the return of the Phillips curve as a major risk scenario for the next one to two years, and one which can be even more severe should the curve return in a non-linear shape. The risks of a more pronounced acceleration in labor costs would rise if labor markets continued to tighten, increasingly so if that tightening were to intensify.
However, this is not our base scenario. We don't expect a significant upward movement in inflation or interest rates in this cycle. The Fed might end its rate-hike cycle at around 3%. We still expect a more volatile year, as investors will have to come to terms with the rise in interest rates and fears about overheating. But the synchronized global recovery should, at the same time, continue to act as a safety net and could prolong stock markets' late-cycle glow. Sudden spikes of volatility cannot, however, be ruled out, even though average volatility is expected to rise only slightly in the medium term.
...and how we position ourselves accordingly in multi-asset portfolio management
In the face of potential volatility spikes, we will not pursue any strategies that take an aggressive short-volatility position. There are certainly more elegant ways of benefiting from volatility or changes in volatility. For example, investors can take advantage of price inconsistencies resulting from the convexity of volatility products. Also appealing is the writing of put options – in other words, covered option transactions. This strategy has become even more interesting due to the slight rise in the average volatility level. The second chart shows an example of how an investment in an S&P 500 put option index would have performed, together with a corresponding cash amount invested in an interest-bearing instrument as collateral. The index performed similarly to the S&P 500 over a period of 20 years, but with significantly lower volatility.
Back to normality
2017 has been a particularly calm year for equity markets. The Vix never topped 20. The chart shows the length of past high-volatility periods.
Almost the same result with less stress
Selling S&P 500 put options yielded similar results as buying the S&P 500 long over the past 20 years, but with less volatility.
