Investment Strategies
Market Calm Cannot Last Forever So Fasten Your Investment Seatbelts - Pictet

Investors should not move from equities and into safe havens such as gold or cash if markets become more volatile, as is likely after a period of considerable calm, argues Pictet Asset Management.
Investors would be mistaken to make a strategic shift from
equities and into safe havens such as gold or cash if markets
become more volatile, as is likely at some point after a period
of considerable – almost eerie – calm, argues Pictet Asset
Management.
Despite recent wobbles due to geopolitical concerns – as
demonstrated to shocking effect last week by the Malaysian
airliner crash – markets have been generally relatively calm. For
example, a popular “fear index” known as the VIX, which tracks
options volatility in the US, is at multi-year lows and lower
than it was prior to the collapse of Lehman Brothers in 2008.
While some investment thinkers frown on the idea that risk and volatility are the same issue, many practitioners still adhere to the idea that more choppy market movements are seen as negative by some investors. Unexpected spikes in volatility, as measured by variation around a mean level, can also hit returns, such as among hedge funds of certain types.
The low volatility has been caused to some extent by a period of
ultra-low interest rates and seeming determination by central
banks to do what it takes to avoid economies tipping into
recession. But such periods of calm seldom endure, argues
Luca Paolini,
who is chief strategist at Pictet Asset Management.
“A rise in volatility will be initially accompanied by market
correction. But if the rise in volatility takes place, as we
expect, against the background of an improving growth outlook,
cyclical, cheap or under-owned markets such as Japan and emerging
markets should prove more resilient than in the past. For the
same reasons, rising volatility would not justify a strategic
re-allocation away from equities into safer asset classes such as
cash and gold,” he said in a recent note.
“Experience shows that sharp drops in volatility are often
followed by spikes, with damaging consequences for investors,” he
said.
Paolini pointed to episodes such as the shift in US monetary
policy, as seen in February 1994; a significant change in the
economic outlook, as occurred during the oil shock of 1990 or the
US inflation scare in May 2006; a “black-swan” type of event in
financial markets, such as the collapse of US hedge fund Long
Term Capital Management in 1998 and, the fall of Lehman Brothers
in 2008 or the 2011 US debt rating downgrade.
“At this point in the market cycle, we believe the Fed is the
main threat to this period of lower volatility. Market
participants are expecting lower interest rates than the Fed’s
own forecasts at a time when leading indicators of both growth
and inflation in the US are picking up,” Paolini continued.
“In other developed economies, the low level of volatility stems
from the fact that many central banks are also maintaining low
interest rates, leaving little policy divergence. However, the
monetary policy path may have already started shifting: New
Zealand and the UK are moving ahead in their tightening cycle,
pushing the short end of their yield curves and currencies
higher. As the experience of the BoE shows, dovish forward
guidance is not set in stone; it can be abandoned if the economic
outlook changes,” he said.
He said there are signs that this low volatility is changing.
“Geopolitical risks remain high in the light of events in Russia,
Ukraine and Iraq, and in the past oil price shocks have featured
among the triggers of a sudden spike in market volatility,” he
said.
He said investors should prepare for a spike in volatility.
“A sudden spike in volatility is likely to hit the most crowded
trades, including European equities and peripheral euro zone
bonds. Credit markets are also very vulnerable, particularly as a
decline in secondary market liquidity could exacerbate price
declines,” he said, but also pointed out that a turn towards more
turbulent markets has its upside: “A spike in volatility would
not be a negative development for all asset classes. Investors
should not assume that the current bull market will come to an
abrupt end just because volatility is going to rise. Rather, a
rise in implied volatility indicates we are merely entering a
mature phase of the business cycle, driven by economic growth
rather than central bank stimulus.”