The Era Of Low Volatility Is Over

by: Columbia Threadneedle Investments

Summary

In 2016, there is potential for unusual or outsized moves in asset prices.

Geopolitical risks in the Middle East that could disrupt oil supplies will need to be closely watched.

Investors need to be more vigilant as we move away from the era of exceptionally low volatility.

By Mark Burgess, CIO EMEA and Global Head of Equities

Black swans, sometimes called fat-tail events, are random or unexpected occurrences, typically with extreme consequences. There are several tail risks that the markets should have on their radar this year, but don't.

Anticipating the consequences of lower oil prices

At a global level, one of our sources of concern is the Middle East and whether faith in lower-for-longer oil prices may be slightly misplaced. Futures markets suggest that oil prices will stay low this year. Popular theory suggests that Saudi Arabia will continue to pump as much oil as it can, not only to weaken marginal producers and reestablish itself as the global swing producer, but also to ensure that regional rivals such as Iran earn as little as possible from oil.

It is true that (current) spot prices are above Saudi Arabia's lifting costs (production costs after drilling), but its fiscal breakeven oil price is much higher. So, the thing to bear in mind for 2016 is that while low oil prices are good for the developed world, and could go lower, they are not particularly good for stability in the Middle East. If there are signs of further instability in the Middle East, oil prices could snap back quickly. Markets are not prepared for that eventuality.

Indeed, the markets more or less discount further money printing from the European Central Bank (ECB) and possibly Japan, and yet, Europe and Japan are the two developed world regions that are most sensitive to energy prices, as they have so little energy of their own. From that perspective, a stronger oil price could be a fly in the ointment for those betting on the fact that the ECB and Japan will fill the quantum easing void left by the U.S.

Monitoring asset prices in a more volatile market

As we move away from the era of exceptionally low volatility, there is potential for unusual or outsized moves in asset prices. In August 2015, we saw some strange asset price moves when equities were slumping and assets traditionally regarded as safer, such as Treasuries, provided little or no diversification benefit. Some emerging market nations and sovereign wealth funds are large holders of developed world assets, and while developed world macroeconomic indicators may be reasonable, this may not translate into good returns from those assets when some holders are being forced to liquidate.

Hold on to your hats: The volatility of volatility index (VVIXSM)

Source: Thomson Financial Datastream, 11/15

In our view, August 2015 was a classic example of price-indiscriminate selling. While this can be very helpful for active managers in terms of creating opportunities to buy, it can be very unsettling for investors who are unfamiliar with such volatility. In some asset classes, these moves could be amplified by the fact that liquidity is poor, and therefore, what should amount to relatively small moves could get blown out of proportion.

Increasing vigilance in 2016

Geopolitical risks in the Middle East that could disrupt oil supplies will need to be closely watched. Market complacency about oil prices could easily be shattered by any signs of instability in the region. Finally, I would reiterate that I prefer equities to bonds, but investors will need to be more vigilant in 2016, because the era of abnormally low volatility is over.

Disclosures:

The Chicago Board Options Exchange Volatility Index (VIX) reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. First- and second-month expirations are used until eight days from expiration, then the second and third are used.

The Chicago Board Options Exchange VVIXSM Index represents a volatility of volatility in the sense that it measures the expected volatility of the 30-day forward price of VIX®. This forward price is the price of a hypothetical VIX futures contract that expires in 30 days. The VVIX is not the same as the expected volatility of the VIX, but the two are close because nearby VIX futures track the VIX.

It is not possible to invest directly in an index.

Asset allocation and/or diversification does not assure a profit or protect against loss.

International investing involves certain risks and volatility due to potential political, economic or currency instabilities and different financial and accounting standards. Risks are enhanced for emerging market issuers.

Commodity investments may be affected by the overall market and industry- and commodity-specific factors, and may be more volatile and less liquid than other investments.

Investing involves risk including the risk of loss of principal.

Disclaimer: The views expressed in this material are the views of the author through the date of publication and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain 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 discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Please see our social media guidelines.