By Mike Dolan
LONDON, July 24 (Reuters) – Economic and political uncertainty have never been deeper in the lifetimes of most investors and yet investor behaviour surrounding such chronic anxiety may, counter-intuitively, be suppressing market volatility.
The past three months have been puzzling for many people as global equity prices return close to record highs, just over 100 trading days after this year’s pandemic shock unfolded and in the midst of the deepest global recession in living memory.
The most basic explanations hinge on massive government and central bank support, near-zero discount rates and the fact that typically forward-looking markets have rushed to price a rapid, vaccine-aided recovery over 12-18 months as lockdowns lift.
But, whether that’s reasonable or not, few doubt the pandemic introduced a swathe of new economic, policy and geopolitical uncertainties – de-globalisation, accelerated digitalisation, a Cold War between the West and China, an unprecedented public debt surge and long-term inflation risks.
Heap those on already rising political anxieties since the banking crash and global recession 12 years ago, as well as pressure to better account for pandemic-style risks going forward, and even add the looming U.S. election, and you might reasonably expect a sustained rise in financial volatility.
A news-based gauge such as the World Economic Policy Uncertainty Index hit its highest in 23 years of data during the pandemic and remains higher than all prior peaks hit after Brexit, the euro crisis, the Great Financial Crisis, the Iraq invasion and 9/11 attacks.
A 120-year Geopolitical Risk Index compiled by Fed researchers Dario Caldara and Matteo Iacoviello also shows the most recent 12-month average has only been surpassed during the two world wars of the last century.
And yet this week, Wall Street’s “fear index” of implied U.S. equity volatility has once again dissipated to levels close to the pre-COVID world in February, more than 3 points below its long-term moving average and less than a third of March’s peak.
The pattern is replicated in currency and debt markets too.
HERDING AND INERTIA
To some, this is the result of more than a decade of central banks reacting to every financial wobble with massive money-printing and liquidity boosts that have anaesthetized markets, corked volatility and mispriced assets – potentially fostering bigger explosions for the future.
But others reckon investor behaviour itself is responsible as uncertainty levels have risen consistently over 20 years.
Barclays analyst Marvin Barth outlined the effects of persistent anxiety about unmeasurable outcomes – what he defined as true uncertainty as opposed to the more predictable risks surrounding routine economic or political events.
Barth concluded that the “fight-or-flight” reactions to sudden surprises or changes to uncertainty levels were still largely as you’d expect – indiscriminate dashes for safety and cash bunkers until the coast has cleared.
But behaviour surrounding persistently high levels of uncertainty was different – more akin to herding and inertia, characterised by an unwillingness to take big, out-of-consensus positions.
The difference between the two is “akin to those between behaviours under acute and chronic stress”, he wrote, adding persistent uncertainty was what we faced in the years ahead.
The net effect, Barth reckoned, is lower average volatility with more frequent but temporary spikes; negative term premia in bond markets along with rising equity risk premia; a vanishing ability to generate benchmark-beating – or “alpha” – returns; and a shift toward private assets and venture capital while handing more liquid portfolios to passive or quant-based management.
“Herding behaviour in markets has the opposite effect of changes in uncertainty on volatility: it suppresses it.”
The report this month, part of Barclays 64-year-old annual Equity-Gilt Study, suggested this explained huge crowding in “safe” AAA assets, regardless of yield, alongside consensus bets to generate returns and an obsession with probabilities from bookmakers on the outcomes to unprecedented events such as Brexit.
“We should expect more benchmark-hugging and inertia in markets while uncertainty is heightened but unchanging, and violent spasms of volatility when perceived uncertainty changes noticeably,” Barth wrote.
All this crowding led to declining bond market “term premia” – one market gauge of future uncertainty – during the pandemic shock this year, even as equity risk premia rose, he argues. It’s also been reflected in higher average spreads for non-investment grade debt over the past decade.
The value of passive funds now exceeds active ones for the first time and average hedge-fund performance has been declining over recent years.
If out-of-consensus bets are then largely avoided, the ability to steal a march on more regular market risks has also disappeared amid an exponential rise in data availability and computational power that means “markets’ efficiency in pricing objective risks is nearing perfection,” Barth wrote.
“If investors face little to no upside potential from active management of objective risks but are exposed to all the downside of uncertain risks, the incentive to hide in the herd is self-reinforcing,” he said.