Why we live in volatile times
Volatility on the Euro-zone equity markets has fallen to its lowest level for five years, following the rally in price which began in March. This is what the market expects to happen. Historically, volatility has always risen during international crises or steep falls in equity prices. Once the crisis is past, volatility falls away again.
Is the Euro-zone equity market now due for a period of low volatility, as equity markets continue to climb on the back of an expected US recovery? Or is a return to previous volatility levels inevitable?
Jean-Pierre Petit and Gildas de Nercy, derivative re-searchers at brokers Exane in Paris, suggest that there are features of the current financial scene that actively encourage volatility, and that we must expect a return to previous levels sooner rather than later. “We believe it is more likely that we shall once again experience the volatility of the turbulent times of the past five years than return to the relatively peaceful period at the beginning of the 1990s,” they say.
De Nercy points out that there is no “inescapable” equity market volatility trend. “What is clear is that there is no kind of general law in the market which tells that volatility has to come down over the long term average.”
The average European equity market share price volatility is currently 30%, the lowest level for five years. The Exane team suggest that the most likely trend is a return to the 35% average of the last five years. The same is likely for European equity market indices. “If you consider the average for the last five years was probably more than 25%, real volatility is likely to be more like 22% to 23%,” he says.
So what is sustaining continuing volatility in the equity markets? Petit and de Nercy identify a number of factors. One is the ‘institutionalisation’ of savings.
Over the past 10 years institutional investors have taken an increasing share of European equity markets institutional investors France increase listed share ownership has increased from 18% to 26% in France, from 10% to 24% in Germany and from 20% to 30% in Italy. This has created blocs of shareholders who behave with increasing uniformity, leading to ‘pro-cyclical behaviour’ – reinforcing market trends.
Another factor is ‘financial globalisation’ and the increasing sensitivity of European equity indices to US equity indices. At the end of last year correlations of the leading European indices with the S&P500 stood at 0.81 for the Eurostoxx 50, O.83 for the CAC 40 and 0.80 for the Dax.
De Nercy says there two reason for this: “First, more and more of the European blue chips look like US and UK blue chips due to the internationalisation of the economy. And second, in Europe blue chip indices are very small. Having an index of only 50 companies to represent the whole of Europe including Switzerland and UK is crazy. These kind of indices are used by a lot of investors, so that means you have a kind of technical correlation due to liquidity concerns.”
Foreign ownership of European shares is also leading to ‘financial globalisation’, he says. The dearth of funded pensions in continental Europe has created a situation where US and UK investors now own 24% of the shares in France listed on the Eurostoxx 50.
The dominance of global institutional investors is having a significant effect on volatility, say Petit and De Nercy. This is because the behaviour of these behemoths is becoming more uniform, a consequence of the growing standardisation of risk analysis methods and limits set by regulators. This is encouraging pro-cyclical behaviour– principally, selling in a falling market and buying in a rising market – which, in turn, is increasing equity market volatility.
“At the same time as institutional investors are getting more powerful they are facing more and more constraints and pressure to maintain ratios
As a result they are more uniform in their behaviour and that basically means that you will have more pro-cyclical pressures,” says de Nercy
“For the insurance companies in Europe, the fall in equity markets itself fuelled downward pressure. And not only insurers are affected. More and more institutions are using Value at Risk for their trading books which means that they have to contain their losses by selling when they reach their limit.
Even the proposed IAS standards encourage pro-cyclical behaviour, he suggests, because they discourage financial intermediaries from holding high-risk assets.
One solution to pro-cyclical pressure lies with governments and their financial regulators, says De Nercy. “The point is that the regulatory constraints are independent of the systematic risk. In very special circumstances it may be better simply to relax constraints and ratios just to stop pro-cyclical pressure building up. That’s something that is implicit in the market because part of the market thinks that in the event of a very big movement the government would allow institutional investors not to maintain the ratio just to save the market. But that point has not arrived.”
Another solution nearer to home lies in diversifying the flow of information. The Exane team argue that the ‘oligopoly’ of rating agencies has helped increase volatility by creating a copycat effect among institutional investors. Rating agencies also play a pro-cyclical role by “following and amplifying trends instead of encouraging the dissemination of leading information about the nature of risks – in short acting ahead of the possible revelation of difficulties”.
They conclude that the market requires a diversity of views if it is to achieve equilibrium prices that represent asset values. “The risk of inefficiency is increased for want of this, with the greater likelihood of bubbles or crashes.”
In the absence of such diversity, volatility, it seems, is here to stay.