12 Jul Crushing Volatilities and Black Swans
Thinking Man Series #20
“The higher the risk, the higher the return” – this is one of the most common and basic academic foundations of finance. Volatility is one way to measure this risk, as well as the return one should expect on an investment. The level of volatility is determined by the possible changes in price over a period of time. As the volatility of all financial assets becomes lower, the additional return expected from investing in these assets also decreases.
An unprecedented event in financial history is currently happening across all capital markets: the volatility levels of equities, bonds, commodities and FX rates are crushing to all-time lows. As can be observed in the graphs on page 4, both historic as well as implied (i.e. projected) volatilities are at lows never before witnessed in the history of the financial markets. And this occurs across different markets! This indicates complacency from investors in each of those markets, or in other words, it indicates that investors are not pricing in larger macroeconomic or geopolitical risks. However, is this truly the case? And more importantly, why is this happening?
We believe there are two main reasons, which deal with the existence of highly distorted markets:
- Super expansive monetary policies from the Fed and other developed central banks like the BOJ and the ECB.
- Central banks clear communication of policy
Super Expansive Monetary Policy
We live today in a world with ultra-low interest rates, and they are here to stay for many more years as economic recovery after the Great Recession is sluggish, and labor markets are improving only at a lethargic pace.
We agree that at some point, short term rates such as LIBOR rates will increase, but we feel they might reach a 2% level rather than their historic 4% average. Also, we believe this will be a very gradual process as the Fed has clearly communicated that any change will depend on economic data, and continues to maintain a posture of “whatever it takes”.
The other critical point which explains why the process of increasing rates will take years is the Net New Issuance (NNI) of US Treasuries. This is simply the difference between the Supply and the Demand of Treasuries. In today’s world NNI is negative, and we predict this trend is here to stay for a long time. Why is this happening? As governments impose fiscal restrictions/limitations upon themselves, the Supply of securities they need to issue decreases. For example in the US, the fiscal deficit is improving enormously and as such, new supply needs decrease on the margin. On the other hand, Demand for Treasuries is very strong from 4 main sources: Pension Funds, International Central Banks, Banks and the ultimate purchaser, the Fed (whose balance sheet ballooned 5 times since 2007). Pension Funds need a constant income stream to satisfy the demand from retiring baby boomers. Central Banks in Europe, Japan, Switzerland and other countries view the US Treasury as high yielding (as their long term rates are below those in America). Banks are boosting their holdings of US Treasuries as they are awash with cash and are not being aggressive lenders (in the same ways corporate CEOs are not heavily investing in Capex, in a world with low “animal spirits”). And if this is not enough, we have the Fed! Thus, global demand far outstrips global supply.
Central Bank Communication
Another way to increase the level of economic activity is to reduce the level of uncertainty. If individuals were more confident about the future direction of the market, there would be much higher levels of both investment and consumption taking place. In the past, Central Banks did not release as much information as they do today, causing investors to be glued in front of their television sets awaiting the next big announcement concerning interest rates. These announcements were unpredictable for the most part, therefore there would be significant and rapid changes in monetary policy. Today, the major Central Banks have been able to achieve this goal of increasing certainty by communicating that they intend to hold a fairly predictable monetary policy- one without any radical changes. Interest rates will remain near zero percent and independent from the next economic indicator release. This elimination of uncertainty has also greatly lowered the volatility levels of financial instruments, ranging from long term bonds, commodities, equities and other securities. All of these investment vehicles are tied to the change in interest rates, therefore with a stable and predictable rate, there is more confidence and certainty in the market.
Can a super expansive monetary policy and heavy government interference continue forever? No, of course not. Global demand dynamics for risk-free bonds like US Treasuries can change at any moment (we saw this in June 2013). Another problem with the current state of the markets is that this reduction in volatility encourages people to take on much larger positions in assets that are perceived as safe under the new volatility levels. The problem with these “safe assets” can arise if there is a change in volatility levels towards the opposite direction. Since these positions are now much larger, they are much more exposed and sensitive to even a small change in volatility.
Our base scenario is that due to the new level of low volatility, markets will continue to rise to new heights, at least for another year or so. However, the Black Swan theory can come back to bite us. As the leading writer in this topic, Mr. Nassim Nicholas Taleb, observes: “Black Swan logic makes what you don’t know far more relevant than what you do know,” because it is the unexpected that shapes our lives. If a Black Swan – an unpredictable or unforeseen event, typically with extreme consequences- does occur, there would be huge losses caused by a spike in volatility risk and the inability of the government to intervene quickly enough.
Thus, we do advise clients to use some Tail Risk hedging. This means budgeting some capital to hedge your portfolio against those situations that you might not be prepared to go through. This depends on each investor’s “stomach”, but today, there is no doubt that buying protection is cheap! Two classic ways of hedging would be buying protective puts on equity indices (like the S&P500) or purchasing Credit Default Swaps.
This material is distributed for informational purposes only. The discussions and opinions in this article are for general information only, and are not intended to provide investment advice. While taken from sources deemed to be accurate, BigSur Wealth Management, LLC (“BigSur” or the “Adviser”) makes no representations about the accuracy of the information in the article or its appropriateness for any given situation. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. BigSur shall not be responsible for the consequences of reliance upon any opinion or statements contained herein, and expressly disclaim any liability, including incidental or consequential damages, arising from any errors or omissions.
Please note this material includes BigSur’s “Strategic Asset Views”, which seeks to identify and reflect the Adviser’s views (opinion) regarding the potential portfolio withstanding of various asset classes. When developing its Strategic Asset Views, BigSur analyzes numerous other factors related to the markets in general and to the implementation of any specific assets class and trading strategy should only be determined via assessing these factors with each individual client’s overall characteristics. Therefore; BigSur provides its Strategic Asset Views for information purposes and for client considerations and prior to any client taking actions based upon these views such activity should be discussed with your individual BigSur advisor accordingly. The companies discussed herein, are for illustrative purposes only and do not represent past or current recommendations by BigSur. This article is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific investor. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. Any securities or products referenced BigSur believes may present opportunities for appreciation over the subsequent time periods. BigSur closely monitors securities discussed and client portfolios and may make changes when warranted as a result of evolving market conditions. There can be no assurance that the securities and performance included or referenced in the article will remain the same and investment strategies, philosophies and allocation are subject to change without prior notice. Specific securities or companies identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed were or will be profitable. BigSur may change its views on these securities at any time. There is no guarantee that, should market conditions repeat, these securities will perform in the same way in the future. Any referenced securities and their respective returns reflect the reinvestment of income and dividends, but do not take into account trading costs, management fees, and any other applicable fees and expenses. Please refer to Part 2A of BigSur’s Form ADV for a complete description of fees and expenses. Actual client performance will vary based on a variety of factors, including account restrictions, guidelines, the timing of investments, and cash flows. Hypothetical performance results may have inherent limitations, some of which are described below. An investor’s actual return will be reduced by the advisory fees and any other expenses that may be incurred in the management of an investment advisory account.
The returns and references to the S&P 500 index are provided for informational purposes only. The S&P 500 Index is a market-capitalization weighted index containing the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The index is calculated on a total return basis with dividends reinvested. In addition, the volatility and securities of the index may be materially different from an investor’s. The S&P 500 Index was selected and is referenced to allow for comparison of the performance of any referenced securities or overall market to that of a well-known and widely recognized index. Comparisons to indexes in this material have limitations because indexes have volatility and other material characteristics that may differ from the referenced strategy or security. Therefore, actual performance may differ substantially from the performance of any referenced index. Investors should be aware that the referenced benchmark funds may have a different composition, volatility, risk, investment philosophy, holding times, and/or other investment-related factors that may affect the benchmark funds’ ultimate performance results. Due to these differences, indexes should not be relied upon as an accurate measure of comparison and are for informational purposes only. Unless noted otherwise, all index returns are denominated in U.S. dollars.
Target exposures included in this article may differ between clients based upon their investment objectives, financial situations and risk tolerances. Investments in general involve numerous risks, including, among others, market risk, default risk and liquidity risk. No security or financial instrument is suitable for all investors. Securities and other financial instruments discussed in this article, are not insured by the Federal Deposit Insurance Corporation (“FDIC”). The income and market values of the securities stated on this article may fluctuate and, in some cases, investors may lose their entire principal investment. Past performance is not indicative of future results.
There is no guarantee that the opinions expressed herein will be valid beyond the date of this article. Certain information included in this article was based on third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed. This information is highly confidential and intended for review by the recipient only. The information should not be disseminated or be made available for public use or to any other source without the express written authorization of BigSur. Such distribution is prohibited in any jurisdiction dissemination may be unlawful. Please contact your investment adviser, accountant, and/or attorney for advice appropriate to your specific situation.
BigSur Wealth Management, LLC
1441 Brickell Avenue, Suite 1410
Miami, FL 33131
Office (Main): 305-740-6777 ext. 8006