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

Tom Burroughes

21 July 2014

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 , 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.”