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07 February 2018

Living with volatility 

The recent plunge in global equity markets appears to be primarily a sign that the market is blowing off the excessive optimism built up in recent months on the back of signs of an ever-strengthening global economy and, in particular, the boost to US earnings following congressional approval of a major package of tax reforms.

Volatility appears to be at the center of the current equity market correction.

Many investors shorted volatility in 2017, making it a crowded trade and leading volatility indices to record lows. Following the current correction, such investors are heading for the exit in droves and volatility is spiking massively, causing carnage in volatility-related trading.

The environment of extremely low volatility that was so characteristic of 2017 is clearly over. Investors should expect more market turbulence. 

The panic in the volatility market is mainly impacting equity markets, while bond markets are relatively quiet, with US Treasuries recouping some of their recent losses and yields dropping somewhat from recent highs. Credit spreads also remain well-behaved, indicating that investors are not worried about the outlook for corporate results in what is still a very strong global economy.

Traditional safe havens, such as the Japanese yen and gold, are stable, which indicates that we are not experiencing major investor panic. The same can be said about the price of oil and major metals, suggesting that investors are not worried about the prospects for the global economy.

The current correction will therefore likely remain limited in scope and size, and is a healthy development insofar as it blows off excessive optimism about the prospects for equities, while at the same time ending excessive speculation in volatility instruments.

We therefore maintain our current overweight position in equities. Still, the correction may undermine investor confidence and even have a negative impact on the global economy, which needs to be monitored closely.

As equity markets recover in the near future, the quality of this recovery must be monitored closely – in terms of momentum and breadth – to determine if the equity bull market is still alive and well. If the recovery lacks quality, expect to see reduced equity exposure. Today, however, it remains too early to make that call.

The statements and views expressed in this article are those of KBL epb as of the date of publication this article and are subject to change. This article is of a general nature and does not constitute legal, accounting, tax or investment advice. While the information in this article has been established on the basis of reliable sources and is therefore presumably correct at the date of publication, it is provided with no guarantee, either express or implicit, as to its completeness, accuracy, authenticity, timeliness, validity or relevance, and no liability is accepted by KBL epb in this respect.