07 Mar 2016

By Shadforth Financial Group

Volatility in investment markets has recently increased and we believe it is likely to remain at elevated levels. Volatility tends to remain subdued when investment markets are bullish and typically complacent, but then spikes sharply as complacency is replaced by fear. As can be seen from Chart 1, the volatility index (VIX) has a long term average level just under 20. We expect it to remain above these levels for the year ahead.

The recent volatility has been partly caused by what we define as the three l's: legislation, liquidity and leverage. These are interlinked and have an impact on volatility.

Chart 1: Long term Volatility Chart (1990 – 2016)

Source: Bloomberg, IOOF Research

Legislation affects liquidity and leverage

The introduction of the Volcker Rule, which prohibits banks from participating in certain investment activities, has helped create an unintended possibility for higher volatility. Before the Volcker Rule, investment banks used their capital to take on risk to either help facilitate their customers’ trading or to make proprietary trading profits. To achieve this, investment banks maintained an inventory of bonds and shares on their balance sheets. They were permitted to take on risk and in volatile markets were able and willing to use their balance sheets to manage their exposure and take proprietary trading positions. This activity created liquidity and helped to dampen volatility.

Since the Volker Rule, investment banks have removed proprietary trading teams and scaled down the capital they are willing to put at risk even though they are allowed to take on some risk to provide a trading service to their clients.

The willingness for investment banks to ‘make a market’ has been scaled back, meaning a whole group of market participants have been removed. This was an unintended consequence of the Volker Rule as less liquidity likely boosts volatility.

Leverage influencing liquidity

Banks and investment banks have traditionally used their balance sheets to provide leverage to hedge funds, investors and even retail investors through the likes of margin lending, financing and derivatives. With the introduction of stricter capital requirements, like those stemming from the Basel Accords, banks are required to maintain much higher levels of capital as well as use stricter lending criteria. The lower supply of leverage has likely drained some liquidity out of investment markets.

With investment banks removed from the equation, it is left to only asset management firms, hedge funds and high frequency traders to provide liquidity to investment markets.

However, this creates a number of problems as traditional asset managers, such as AMP or Fidelity, are rarely forced buyers or sellers other than when managing their net inflows and outflows of capital. They can wait out periods of volatility, but by not trading this has the potential to exacerbate volatility. High frequency traders and some hedge funds have also been providers of liquidity but they too can swiftly withdraw their liquidity.

Leverage can also boost volatility

During the last few decades, the proliferation of financial engineering and financial products like derivatives, exchange traded funds, margin lending and the increasing use of shorting has resulted in extra leverage being introduced into investment markets. Using leverage to amplify returns can sometimes create further volatility as investors are forced to cover positions, meet margin calls or even have their positions forcefully closed. Investment markets have become exceptionally focused on the short-term. Quantitative funds, high-frequency traders and retail investors often vie with each other to try take advantage of the impact of every tiny bit of news. Consequently, we believe that this will continue contributing to market volatility.

Quantitative tightening

Global quantitative easing has left investment markets awash with cash. Unfortunately, we are now at a point where market participants are trying to come to grips with the unwinding of quantitative easing and the potential increase of interest rates in the United States. At the same time we are witnessing mixed economic data across the world and faltering GDP growth, combined with increasing risks around deflation, emerging markets, credit and interest rates.

The leverage already within the system, combined with the withdrawal of liquidity as quantitative easing pulls back, leads us to believe volatility is likely to remain elevated for a while.

We believe investment strategy is a long-term undertaking, especially in the context of superannuation. Consequently, we believe it is important to focus on your investment objectives and try avoid the distraction that media noise and volatility often plays in impacting investment decision making.

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