Benign Economic Environment, Low Market Volatility
Low volatility has been the hallmark for this year’s market. We have seen the lowest level on record for the volatility index (VIX) and the lowest realized volatility in the S&P 500 Index. The reason we have such low volatility in the market is clear: The macro environment is very benign and investors know it.
Looking at the market now, here is where we stand:
- Economic growth is decent, but not spectacular, and we are seeing synchronized growth globally for the first time since 2008.
- Inflation is low but there is no risk of deflation. Low inflation means the Federal Reserve (Fed) is in no rush to tighten monetary policy, another positive for risk assets.
- The job market is robust with limited wage pressure. Consumers’ balance sheets are fairly healthy and they are spending.
- Corporate earnings went down in 2015 and 2016, but they are rebounding strongly this year. In the first quarter of this year, S&P 500 Index earnings were up 13% year-over-year. In the second quarter, earnings were up 10%.
This benign environment provides the fundamental support for such low volatility this year. Most investors recognize this, and they are not looking at every data point for confirmation, therefore reducing the impact of major economic data releases on the markets. For example, the options market usually prices in a 6 to 7 basis points (bps) move for the 10-year Treasury rate when the jobs report is released. However, in the last three months, the options market only priced in 3 to 4 bps moves because investors know the job market is robust and they are not changing their view or positioning based on one data point.
Technically, we have $158 billion flowing into equities year to date, which is the second highest equity inflow since 2008 (the largest inflow happened in 2013). Strong equity inflows support the equity markets. On TD Ameritrade and Charles Schwab’s earning calls, both mentioned near record new account openings. This might be because of the recent cut in trade commissions, but also a reflection of the high participation of retail investors in the stock market this year.
This extremely quiet market makes a lot of investors uneasy. However, as I have shared in the past, even though asset valuation is rich and I see many possible reversals that make me uneasy, there is no widespread excess in the economy. This makes the current market very different.
In past cycles, when a recession starts, the Fed eases and asset prices start to recover, prompting an economic recovery soon after. This time, the economic recovery after the 2009 asset bottom was very feeble, and we were experiencing the Euro crisis and commodity bust. These factors forced the Fed to ease aggressively and persistently. After eight years of monetary stimulus and the second longest bull market in history, we are finally starting to see the return of the “animal spirit.” In short, the financial asset valuation recovery has been running ahead of the economic recovery this time, because the asset market has been used to stimulate the economy via the wealth effect. This is also how we get to today’s environment of decent economic growth, very low volatility and rich asset valuation.
Volatility tends to revert to the mean. Currently, market volatility is very low because of a decent economy, strong corporate earnings and the return of the retail investors. Looking forward, I will watch inflation data and bond yields. Higher inflation or bond yields will be a signal for higher market volatilities.
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