2017 was the year when equity markets posted unbroken monthly gains and volatility was conspicuous only by its absence.
Now we have the first quarter behind us it may be a good time to look at recent volatility and ask what was behind it and what can we expect in the future.
After a record start for equity markets in January, major global equity markets have since sold off aggressively. New records were set. One indicator, the volatility index known as the Vix, increased more on 5th February than on any single day in its history in both points and percentage terms.
Despite this, it is important to bear in mind that when looked at in a historical perspective, neither the equity index losses nor the actual levels of volatility that occurred were particularly unusual. They only appear so when set against the extreme calm of the previous 15 or so months.
Was there a reason for this surprisingly volatility? Many point to the February US non-farm payroll data that appeared to ratchet up concerns about higher inflation and interest rates. However subsequent events do not bear this out. If Federal Reserve policy tightening was the culprit, then it would have been correct to expect so-called ‘bond proxies’(high dividend and low volatility stocks that offer the safe and predictable income qualities of bonds) to underperform other equities. But this did not happen; the sell-off was highly correlated across regions, sectors and styles.
This interest rates/inflation theory was dealt another blow when despite US inflation data showing a far sharper increase than expected and 10-year US Treasury yields touching 2.9 per cent for the first time in four years, equity markets went off.
This all leads to deduce that the selloff was largely technical driven. However, this does not make it irrelevant for longer-term investment considerations.
In recent weeks, we have seen systematic selling in equity markets by market participants using algorithms. Recent events have highlighted their potential to instigate and sustain destabilising feedback loops in both volatility and underlying asset markets.
Financial markets are increasingly susceptible to these technical crashes as the use of algorithms and passive rules-based approaches continue to grow. They can of course have a significant impact on both investment performance and investor sentiment by greatly amplifying corrections that have the root in more fundamental concerns.
Looking ahead although the selloff was technical it may well be the start of a shift in investor sentiment. We are likely to see higher volatility in equities as well as other asset classes, regardless of market direction. But before investors make for the hills, it is important to remember that this is merely a return to more normal levels of volatility. 2017 was certainly not the norm.
Considering everything though the patient is alive and well.