Over the past 10 years, capital markets have been subject to a series of shocks. In the foreign exchange markets, the prime examples have been the ejection of sterling from the European Exchange Rate Mechanism and the collapse of a number of the Asian currencies in 1997. In the bond markets the major shocks have been the sharp rise in yields in 1994 triggered by the change in Federal Reserve policy and, more recently, the fall in corporate bond markets and notably the disfunctionality of the high-yield sectors over the past 18 months.
Most publicity is however obviously given to equity markets, where there has been a clear trend increase in volatility. In the case of the S&P 500, implied volatilities averaged 10–15% from 1994–97. After the spike at 40% in 1998 at the time of the Russian debt default and the LTCM rescue package, they have averaged 20–30% over the past three years. Ignoring the 1998 exceptional movement, recent US equity market volatilities have on average been double those of five to seven years ago and a similar picture is seen across all other equity markets. Therefore, whereas in the foreign exchange and fixed income markets, relative stability has returned after a macro or ‘event’ shock, the pattern in equity markets has been different – one of a medium- to long-term increase in volatility.
The key questions are whether this equity market development will in the future be reflected in the FX and bond markets and if future volatility will remain high across all asset classes.
In answering these questions, it is important to analyse the different influences of, firstly, macro economic factors and, secondly, potential changes in capital flows and thirdly market technical factors.
Historically, macro economic shocks to markets have been due to rigid price relationships being broken or to “bubble like” conditions being allowed to develop. The best examples of unsustainable price rigidities have been the ERM in the early 1990s and other currency pegs that have not been justified by economic fundamentals. The over-valuation of TMT equities during early 2000 was the best recent example of excess demand chasing valuations to extreme levels. Market over-valuations are typically against a background of low real interest rates, strong economic activity and rapid money supply growth. Although the past 18 months has clearly seen the TMT bubble being burst, arguably the current low level of interest rates and monetary expansion shows the potential for creating future renewed bubble conditions over the next one to two years. In addition, there is a high probability that the next few years will see greater volatility in economic growth amongst the G7 countries; apart from changes in monetary and fiscal policies, one source of economic volatility could be ‘just-in-time’ inventory management by corporations. Running low levels of inventories means that companies have to be much more flexible in responding to changes in demand and, inter alia, this could result in greater changes, both positive and negative, in corporate earnings and in economic growth. All of the above will result in a higher economic impact on market volatility in both equities and also in corporate bonds.
The past three to five years have seen much higher levels of capital flows both across markets and borders and between asset classes. Clearly, deregulation has encouraged cross-border flows as has the change in equity markets from country to sector management. Within Europe, the creation of the euro has acted as a catalyst in encouraging flows between markets since there has been an obvious trend away from investors focusing on their domestic markets. Likewise, outside the Euro-zone, both retail and institutional investors are increasingly buying global or cross-border products. In fixed income markets, capital has been attracted to the corporate and high yield bond markets. The latter has seen in the past year major underperformance given increased default rates and lower recovery levels, while the investment grade corporate bond market has suffered from widening credit spreads and credit downgrades. Market volatility in fixed income will rise as capital flows move more rapidly between government and corporate markets and driven by the increased frequency of credit rate changes. Arguably, market volatility in any asset class will be higher with the globalisation of capital flows, the increased level of investment in market related rather illiquid assets and with the higher volume of savings which are directly invested in markets rather than with the banking system. All these factors will remain in force in coming years and should lead to further market volatility.
Technical factors in securities markets are also leading to greater market volatility. Although there has been much publicity about the role of the ‘day trader’, this factor seems exaggerated; however, there has been a major increase in retail direct investing in equity and fixed income markets and the evidence available clearly shows that retail investors have become more short-term orientated in their investment horizon.
For example, one reason given for the weak performance of the German equity market during the third quarter has been the withdrawal of retail funds. Over the past year there has been an unprecedented flow of retail and institutional capital into hedge funds. The hedge fund industry has changed, with the number of macro or directional funds declining and with the bulk of the growth being in long/short funds. These funds have, rightly or wrongly, been broadly criticised for the sharp downward movement in certain equities over the last six months. Although it is difficult to quantify the hedge fund impact on equity markets, it is clear that the volume of short selling and the related level of stock lending has been a source of major volatility.
The structure of equity markets has seen major change in recent years. Firstly, given the high levels of merger and acquisition activity, equity markets have become more concentrated. This factor has been a catalyst in boosting cross-border investment as investors seek diversification, but in turn has been a source of volatility. Secondly, one positive development has been improved liquidity in equity markets as stock exchanges have merged or combined resources. The development of the Euronext is the prime example of exchange consolidation and, in the coming years, it is inevitable that smaller or regional exchanges will be absorbed by those in the key financial centres. While investors should welcome the improved liquidity and transparency that will result, there is clearly the risk that this development will lead to greater market volatility.
It is paradoxical that the factors described above will not directly impact on those markets where central banks or governments have the greatest influence, ie, the foreign exchange and government bonds markets. In equity markets and corporate bond markets, where the abilities of the authorities to intervene are less evident, economic factors, capital flows and technical influences all point to the increase in volatility in recent years being maintained or even becoming more pronounced. This development will naturally lead to greater emphasis by at least institutions and probably by retail investors on risk management and the asset management industry will have to devote even greater resources to this key area.
Robert Parker is deputy chairman of Credit Suisse Asset Management in London

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