IQ INSIGHTS. Volatility: Causes, Threats, and How to Protect Against It

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1 IQ INSIGHTS Volatility: Causes, Threats, and How to Protect Against It November by Bill Street, Head of Investments, EMEA Markets have been somewhat tamed by central banks through a combination of forward guidance and centralising monetary policies. We find ourselves amidst a lowvolatility, low-volume, low-conviction bull market. The S&P has almost tripled since the depths of the financial crisis and sovereign bond spreads have collapsed well beyond pre-crisis levels. The VIX a measure of equity volatility has been low since start of 212, at or below pre-gfc levels. The VIX increased sharply in July as macro and geopolitical risks grew, so we ask the question: Are investors conditioned to this low volatility environment and possibly too complacent? While not our central case, there are plenty of potential pitfalls on the horizon in the form of macro and geopolitical risks. We therefore pause and take stock, and consider whether it might be prudent to be cautious and put in place strategies that provide downside protection. What is Volatility? Volatility is the statistical measure of the dispersion of the price of a security or basket of securities. Realised volatility is the historical statistical calculation of dispersion; whereas implied volatility is the market estimation of future volatility over a given period of time. Volatility expresses the amount of uncertainty pertaining to a securities price, and is therefore an important factor to consider in portfolio management. Equity volatility, and even more specifically the VIX, is usually thought of as financial market volatility. The VIX measures the market s expectation of 3-days volatility of the S&P 5, derived directly from index option prices. Since volatility often signifies financial turmoil, the VIX is often referred to as the investor s fear gauge. 1 Figure 1: VIX Levels Aug VIX Index QE VDAX Index Past performance is not a guarantee of future results.

2 Figure 2: Market & Geopolitical Events and Their Effect on VIX Levels 25 2 Italian Political Deadlock Taper Caper Boston Marathon Bombing US Gov. Shut Down Syria Escalation EM FX Sell-off Taper Caper 2 Earnings Season Russian Tension Russia & Banco Espirito Fears Malaysia Air Plane Shot Down 15 Mar May Jul Nov Mar May Jul VIX Index Long Term Average Past performance is not a guarantee of future results. Causes of the Low Volatility Environment It is not just US equity volatility that has been low European equity, interest rate and FX volatility levels are also at neardecade lows. Central banks have sought to bring market stability via ultra-loose and accommodative monetary policy, and in this they have been largely successful. Volatility is driven by uncertainty and through coordinated monetary policy, together with bond purchases and more recently forward guidance, uncertainty has indeed been extraordinarily low. Markets shrugged off a number of macro shocks and geopolitical events during this time of extended low volatility, and in only 4 instances reached the long-term VIX average level of 2. There is some concern amongst investors that such a low level of volatility is creating complacency, which could ultimately spell trouble and precipitate the next correction. Fed Governor et Yellen echoed this at a recent press conference; saying that low volatility may induce risk-taking behaviour that, for example, entails excessive build-up in leverage or maturity extension, things that can pose risks to financial stability later on. The extent of the leverage build-up is startling and NYSE broker margin debt has climbed at a faster rate than the market since the crisis to an all-time high in February this year. In leveraging up with the help of cheap money, investors are adding risks to the market. Low volatility combined with a need for higher yield has driven investors further up the risk spectrum. Increased leverage in the market would amplify the damage caused by market shocks, and hence investors are understandably worried. There are fears that when this rate cycle starts, the rush to exit bonds will be worse than we have seen in previous bond routs, so losses and volatility may be accentuated by the large inflows and artificially low rates. Volatility is expected to rise as the advanced economies follow increasingly divergent paths with their monetary policy. The US and the UK are deliberating on their tightening paths, while the ECB is only just preparing for its next wave of policy announcements. This could well be enough to force volatility from its subdued state, but there are also risks on the horizon that could cause a more sudden rise. What Could Cause Volatility to Suddenly Rise? I. Macro Risk Forward guidance has been a substantial contributor to market certainty and therefore lower market volatility, and central bank guidance will continue to play a part as we navigate out of this period of ultra-loose monetary policy. Central banks have promised to act slowly and cautiously, and this has been priced in with markets expecting gradual moves over the next 3 years. An interest rate hike in early 215 is anticipated, but the manner and circumstance surrounding it has the potential to derail central banks previous accomplishments. Figure 3: Margin Debt is Rising Faster than the Market Billions NYSE Margin Debt S&P (Rhs) Source: Bloomberg, NYSE Market Data. State Street Global Advisors 2

3 Figure 4: Eurodollar 9-Day Future Implied Probability 6 4 Figure 5: Oil Production Thousand Barrels Per Day % of World 1 Russia 1, Saudi Arabia 9, US 7, China 4, Canada 3, Iran 3, Jun Iraq 3, UAE 2,82 4 The heatmap shows likely future scenarios of the underlying rate.the middle of the heatmap is the most central outcome. Ironically the greatest shock could come from surprisingly good data, particularly inflation. Keeping inflation under control is in theory the primary objective of central banks at best, rising inflation would speed up the Fed tightening, but at the worst it could lead to more severe action. Investors are looking to US payrolls as they speculate over the timeline for Fed interest-rate increases after faster-than-estimated economic and wage growth. Surprise wage inflation may well lead the Fed to hike sooner and faster than markets expect, and in turn end the low-volatility regime. Whilst weaker growth is a worry, in terms of uncertainty it would encourage the persistence of the status quo and markets are comforted by this to some extent. Severely weak growth would pose a risk however, but we predict US growth will be robust and anticipate GDP growth at a rate of 2.8% and 3.3% 2 in and 15 respectively. II. Geopolitical Risk The markets have shrugged off a number of geopolitical events during this extended low volatility period a Thai coup, civil unrest in Turkey, Egypt and Syria, to name but a few. Geopolitical events have been grabbing the headlines of late, and whilst heightened geopolitical risks could hurt economic growth 3 as Mario Draghi recently noted, we don t believe current threats have the capability to send markets into pandemonium. After months of conflict, the crisis surrounding Russia s intervention in Ukraine has entered a new phase for investors through the issuance of sanctions, and Russian retaliatory counter-sanctions. There are concerns about the impact of these sanctions on European growth and particularly for Russian-exposed companies. Whilst trade exposure is relatively straightforward, the financial network stemming from Russia is far harder to decipher and financial exposure via the banking system has the potential to be more toxic should this escalate further. 9 Kuwait 2, Mexico 2,562 3 Source: EIA, as of 29 tember. Iraq is another region embroiled in conflict, and together with Russia they produce over 17% of global oil, therefore oil disruption cannot be ruled out if escalation continues. However, we believe that macro conditions will be the main driver but we continue to monitor the geopolitical situation closely. Is it Time to Think About Downside Protection? A sudden shock may not be our base case, but after a 5-years equity rally, markets are at the higher range of what we would consider to be fair value, so in the short term it may be worth considering adopting a more prudent stance. Aggressive de-risking can prove costly should the markets continue to rise, and a defensive stance risks missing continued upside potential, particularly against the backdrop of ultra-low interest rates and QE. In light of this, we think that considering implementing downside risk protection while costs are low may make sense. Our experience has been that it is always better to start implementing portfolio decisions when others are greedy, and when there is time to consider alternatives and also when the cost of implementing these decisions is low. When markets are in crisis mode as they were in August 211 and tember 28 it is often simply too late. There are a number of ways to optimize the balance of needs through a variety of overlay and direct investment strategies. In particular, we would now put forward Target Volatility Triggers (TVT), which seek to provide downside protection and potential upside participation. State Street Global Advisors (SSGA) TVT dynamically adjusts the exposure of assets within a portfolio in order to target a level of portfolio risk. The approach seeks to provide a stable portfolio volatility level and lower equity beta in volatile periods as well as drawdown protection. Whilst often misunderstood, volatility is not the same as risk, and we reiterate that volatility and returns are inversely correlated. The tail risk protection of the TVT strategy is provided at a very low cost and adds excess return when equity index returns are most negative. State Street Global Advisors 3

4 Figure 6: Rolling 12-Month Drawdowns Other relevant solutions might include Market Regime Aware Investing through our Flexible Asset Allocation framework, which seeks to provide downside protection and potential alpha generation, and overlay programs using listed futures and options to create put-spread or put-spread collar strategies that have historically provided downside protection. 1 VIX Fact & Fiction, May The above targets are estimates based on certain assumptions and analysis made by SSGA. There is no guarantee that the estimates will be achieved. 3 ECB press conference, 7 August Dec The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. Please see appendix for more information. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. State Street Global Advisors 4

5 ssga.com State Street Global Advisors Worldwide Entities Belgium: State Street Global Advisors Belgium, Chausse de La Hulpe 12, 1 Brussels, Belgium. T: , F: SSGA Belgium is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Dubai: State Street Bank and Trust Company (Representative Office), Boulevard Plaza 1, 17th Floor, Office 173 Near Dubai Mall & Burj Khalifa, P.O Box 26838, Dubai, United Arab Emirates. T: +971 () F: +971 () France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number: Registered Office: Immeuble Défense Plaza, rue Delarivière-Lefoullon, 9264 Paris La Défense Cedex, France. T: (+33) F: (+33) Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D-8333 Munich. T: +49 () F: +49 () Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number: Member of the Irish Association of Investment Managers. T: +353 () F: +353 () Italy: State Street Global Advisors Italy, Sede Secondaria di Milano, Via dei Bossi, Milan, Italy. T: F: State Street Global Advisors Italy is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-3, 166 JR Amsterdam, Netherlands. T: +31 () State Street Global Advisors Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-827 Zurich. T: +41 () F: +41 () United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered Number: VAT Number: Registered Office: 2 Churchill Place, Canary Wharf, London, E14 5HJ. T: F: The views expressed in this material are the views of Bill Street and Joe Soave through the period ended 3 tember and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Past performance is not a guarantee of future results. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA s express written consent. The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (24/39/EC) and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor s or potential investor s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. Derivative investments may involve risks such as potential illiquidity of the markets and additional risk of loss of principal. Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. This communication is directed at professional clients (this includes eligible counterparties as defined by the Financial Conduct Authority. who are deemed both knowledgeable and experienced in matters relating to investments. The products and services to which this communication relates are only available to such persons and persons of any other description (including retail clients) should not rely on this communication. Investing involves risk including the risk of loss of principal. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. The simulated performance shown was created by the Investment Solutions Group (ISG). The returns were generated by using Target Volatility Triggers (TVT), a proprietary portfolio management tool developed by SSGA s Investment Solutions Group. TVT uses historical measures of realized volatility within the portfolio in order to forecast future volatility. Portfolio weights are dynamically adjusted based on the volatility forecast in an attempt to target a given level of realized volatility for the portfolio. The results shown do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight. The simulated performance was compiled after the end of the period depicted and does not represent the actual investment decisions of the advisor. These results do not reflect the effect of material economic and market factors on decision-making. The simulated performance data is reported on a gross of fees basis, but net of administrative costs. Additional fees, such as the advisory fee, would reduce the return. For example, if an annualized gross return of 1% was achieved over a 5-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 54%. The performance includes the reinvestment of dividends and other corporate earnings and is calculated in US dollars. The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. Standard & Poor s (S&P) S&P Indices are a registered trademark of Standard & Poor s Financial Services LLC. State Street Corporation. All Rights Reserved. ID259-INST Exp. Date: 3/9/215