Special Report Outlook 2015: Fear gauges refuse to budge
One of the defining characteristics of 2014 has been the return of geopolitical risk. For months there has been a constant stream of de-stabilising news from around the globe – from Russia’s annexation of Crimea to the advancement of Islamic State, pro-democracy demonstrations in Hong Kong and the spread of Ebola in West Africa and beyond.
Take out the early-October blip, however, and markets have proved remarkably sanguine. Even the Three Horsemen of Market Apocalypse that often do well in these circumstances – oil, market volatility and gold – have failed to turn up. To unpick why market behaviour has been different this time, each asset needs to be more closely examined.
One of the great surprises of the year has been the collapse in the price of oil – after a modest spike in the summer it has since fallen by around 20%.
Alastair Baker, multi-asset fund manager at Schroders, says: “This steep price cut has been driven by a radical change in oil market dynamics, with supply increasing dramatically while demand has softened.”
The increase in supply has come from a number of different quarters. Take Libya, for example. Despite the government being driven out of Tripoli and onto a car ferry, oil supplies have re-started and the country now produces around 800,000 barrels a day.
Iraq has scarcely been a haven of peace and security, either. But as Harish Sundaresh, commodity analyst at Loomis Sayles, says: “It would be reasonable to assume that oil production would drop in Iraq because of the conflict but, actually, the Kurds got more autonomy and the country is now exporting more than ever.”
At the same as supply has increased, demand for the black stuff has fallen. Baker says: “Over the summer, demand weakened in Europe. Leading economic indicators like PMI have softened considerably in recent months, indicating that demand is likely to remain low.”
While these factors caused the price of oil to fall over the summer, recent moves by Saudi Arabia caused the price to decrease further. Announcements made by the Saudis have a strong influence on the price of oil because they are effectively the central bank of the oil market, with the ability to increase or decrease supply.
Baker says: “The oil market was expecting the Saudis to cut back their oil supply in response to the increase in supply from Libya, but they surprised the market by saying they were happy for the price of oil to be priced between $80/bbl and $90/bbl.”
While the exact motivation for this move is unclear, a reasonable assumption is that it is a way of providing some stability to the Middle East. “We should not underestimate how unnerved the Saudis are by the threat from Islamic State,” Baker says. “By providing a market surplus, they are effectively providing a cushion for any future price spikes.”
Just as surprising as the falling price of oil, has been the lack of price movement in the equity markets, with implied volatility only starting to rise in early October. But just as specific supply-and-demand dynamics have been supressing current oil prices, similar factors have also kept a lid on equity-market volatility.
In recent years there has been a proliferation of structured products targeting volatility. “Volatility is the only asset class which has seen turnover and volumes increase since the financial crisis,” notes Andy Warwick, lead portfolio manager for BlackRock’s Dynamic Return Strategy fund.
Long-volatility trades are made to hedge against equity downside risk and, like other forms of insurance, there was a premium attached to these trades. “But over time that premium has been dissipated as the number of players looking to harvest the returns has increased,” says Warwick.
The key driver for the large increase in the number of players in this market has been investors’ search for yield. Tim Edwards, director of index investment strategy at S&P Dow Jones Indices, says: “Every time there has been a small spike in volatility that’s been treated as a selling opportunity by those players, which has had a dampening effect on the Vix.”
Central bank policy has also played a role. Warwick says: “The huge amount of monetary stimulus in the system has effectively kept both fixed-income and foreign exchange rates at very stable levels, which has helped to dampen volatility across all asset classes.”
Paul O’Connor, co-head of multi asset at Henderson Global Investors, says: “The behaviour of the central banks not only explains the movements in the value of the dollar but also changes in the price of gold over the past four years.”
When the US Fed eases monetary policy, the value of the dollar falls and the price of gold rises. O’Connor says: “Paradoxically the value of gold started to rise while other asset prices were rising because it became so linked to central bank liquidity, rather than being a safe haven.”
Sundaresh agrees: “The price of gold is closely linked to the value of the dollar. As the value of the dollar fell at the start of the year, gold rallied.”
Over the course of the year, however, geopolitical risk has started to have some influence on the value of gold. “A combination of geopolitics and low interest rates have kept gold pretty stable despite the dollar rising since July,” says Sundaresh.
The ability of central banks to effectively tranquilise financial markets and mute their reaction to the uptick in geopolitical risk is only possible because monetary policy is currently so unorthodox.
The exceptionally high levels of liquidity provided by QE and ultra-low interest rates have made macroeconomic policy the only game in town. Markets have reacted only when the time horizon on interest rate increases is either contracted or expanded.
For some, the recent return of volatility to equity markets and the collapse in US Treasury rates should be viewed as a positive, rather than a negative. O’Connor says: “The recent sell-off and the spike in equity market volatility are the
first signs that we are beginning to come an end of the end of the era of the omnipotent central bank.”
Next year, both the US Federal Reserve and the Bank of England are likely to start to increase the cost of borrowing, and the ECB’s planned re-purchase of asset-backed securities and covered bonds will have limited impact, he adds. The Bank of Japan showed it still had the clout to surprise markets at the end of October, but even here there is evidence of diminishing returns.
“Markets have to confront a world where there will be much less central bank support and one where central bank policy stimulus has peaked,” says O’Connor. That’s a world where financial markets will be more alert and much more likely to react rapidly to meaningful geopolitical risk.