Dreading “volatility” only on the way down.
“It’s too quiet out there,” BlackRock Global Chief Investment Strategist Richard Turnill wrote in his market commentary. “Low volatility and inflation expectations look unsustainable.”
Volatility isn’t low because things are great. It’s low because the Fed and other central banks have “played a role in suppressing” it with their QE programs, he said. And between 2012 and 2014, they “dulled market volatility to unprecedented low levels.” But that ended in 2015, as the Fed, after having ended QE, began to flip-flop about raising rates.
It must be said that surging “volatility” – as measured by the Volatility Index (VIX), which represents expectations of 30-day price volatility calculated from S&P 500 options – isn’t associated with jumping stock markets but with swooning markets.
Volatility shot sky-high during the Financial Crisis and in late 2008 broke through 80 for the first time ever. At that point, QE was announced, and the VIX descended. In early 2010, it was back in the teens, and solidly below 20, the average since 1990.
But in June 2010, as QE ended, the VIX skyrocketed past 40. With “fear” suddenly pulsing through the markets, Wall Street screamed for more QE, and the Fed listened, and QE-2 rumors started floating around. Soon QE-2 appeared on the horizon. The VIX settled down and for much of QE-2 remained in the mid-teens. Then QE-2 ended … and voila!
The VIX shot up to 50 and continued to bounce around at high levels until QE-3 rumors started circulating. By the time QE-3 started, the VIX was below 20. For most of QE-3, the VIX remained between 10 and 20. Complacency, somnolence, euphoric dreaminess come to mind.
Then QE-3 was tapered out of existence, and the VIX has since bounced around a lot. On August 12, 2015, it was at 12.8. But a few days later, all heck broke loose, and the VIX shot up to 40! It spent January and February this year between 20 and 30. But then the ECB kicked off additions to its QE and NIRP programs, and the Bank of Japan shot another arrow, and the VIX once again sank into somnolence, to 13.8 today, the lowest level since mid-August just before all heck had broken loose.
The markets “have become eerily quiet recently,” Turnill said. And that’s “unsustainable.” Because there are some risks:
This unusual calm follows declining market concerns about sliding oil prices, and the health of China’s economy and European banks. We do not expect this to last, and see a return to the higher-volatility regime that was the norm prior to QE.
The future path of monetary policy remains uncertain, and tail risks remain. A big Chinese yuan devaluation isn’t our base case, but it’s a downside risk. Geopolitics, particularly as Europe confronts terrorism and migration, could spark volatility.
Then there’s inflation. Fed Chair Janet Yellen said today that she expected inflation to rise “gradually” to the Fed’s 2% target. But that 2% is based on the Fed’s preferred measure of inflation, “trimmed mean PCE,” which is currently 1.84%.
The collapse in prices of energy and other commodities, such as corn, has pushed down inflation as measured by headline CPI to 1%, though it too is rising. But inflation as measured by core CPI already hit 2.34%, the highest since 2008.
If you rent in the Bay Area and other hot spots, or if you need healthcare or have kids in college, forget it. And if oil prices rise significantly – we doubt they will now, but they will someday – and if other things do what my favorite chocolates with 86% cocoa just did, though cocoa is trading at the lowest level since early 2015, then inflation is going to bite. And in this near-zero yield and low-wage-growth environment, higher consumer price inflation will eat nearly everyone’s lunch.
Yet, despite these visions, the public expects inflation to average 1.65% for the next 10 years, according to the Cleveland Fed. The bond markets peg the 10-year breakeven inflation rate at 1.56%, though that too has shot up from 1.18% in early February. And Pimco’s Mihir Worah declared on a company video in early March: “The market is pricing 1% inflation in the U.S. for next year; we think it’s likely to be closer to 2%.”
In short, the financial world isn’t even willing to contemplate inflation! But that could change. And that’s another risk.
While a “modest” increase in inflation expectations might “support riskier market segments,” such as emerging market stocks and commodities, according to BlackRock, “these assets could suffer in the longer term if the Fed were seen to be falling behind the curve, raising expectations of sharper rate hikes.”
By the sound of Yellen’s speech today, the Fed is bound and determined to fall behind the curve! So, in order to prepare for “higher volatility” and the market mayhem it can drag along, the report suggests:
- Buy gold, which “can be an effective hedge if volatility spikes due to rising U.S. inflation fears.”
- Buy Treasury Inflation-Protected Securities (TIPS) and “similar instruments.”
- And diversify away from the dollar and get some “foreign-currency exposure.”
In order to buy these goodies, investors need to unload something else. But what? The report is silent on the topic. A sell recommendation would go too far for the biggest money manager in the world. It certainly doesn’t want to create a stampede out of stocks, for example.
Bond-fund specialist Pimco is singing from the same page:
“If you look at inflation expectations as they are reflected in the bond market, we think they are too low,” Pimco’s global economic advisor Joachim Fels told Bloomberg TV. “We still think markets are pricing in too low a profile for inflation.”
As stock and bond markets adjust downward with big bouts of volatility, seat belts might be required for the ride. That’s their theme. But if you’re sitting on some gold, TIPS, and foreign currency exposure – such as yen, God forbid? – you might have a smoother ride.
In this debt-fueled economy, the “hangover from years of lenient credit may become painful,” according to ratings agency Standard & Poor’s. Read… “Spike in Defaults”: Standard & Poor’s Gets Gloomy, Blames Fed
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