Volatility has been unusually low for a long time now, with the US VIX ‘fear index’ having traded close to an all-time low for pretty much the whole of 2017. The previous time volatility was at levels so subdued was in 2007. Even though history never quite repeats itself, this makes investors worried, as this previous bout of low volatility turned out to be a prelude to the worst market crash since the 1930s.
Just like high tide follows low tide, a period of very low volatility must be followed by one where volatility is higher, the reasoning goes.
However, by following such logic investors “risk to be under-risked”, according to Richard Turnill, global chief investment strategist at Blackrock. As the chart below shows, periods of low volatility are the norm, and are interchanged infrequently with bouts of high volatility.
“Volatility does not follow a normal distribution, our analysis of US market data since 1872 shows. This implies we should not necessarily expect volatility to revert to a historical mean. Markets are either in a low- or in a high-volatility state,” says Turnill.
As you can see on the chart below, a switch from low to high volatility is usually triggered by a turn in the economic cycle. Bears like to point out that the current cycle is the longest in modern history, suggesting we should therefore be close to a turning point. However, Blackrock contends, “the economy’s sluggish growth means that the current cycle has a long way to run (…) Today’s low-volatility regime may therefore persist for longer than many expect.”
The fact that index trackers have become such an important force in many equity and bond markets probably also plays a role in volatility being as subdued as it is though. And the rise of index trackers in fixed income increases the risk for bond markets to be thrown off balance, acknowledges Blackrock: “Poor liquidity in credit markets makes it tough to exit positions quickly and could worsen any selloff. Rising corporate leverage could exacerbate these risks.”