Will The Rise In Volatility Lead To Contagion?

With the US Federal Reserve considering raising rates while the Bank of Japan, European Central Bank and Bank of China are looking to loosen policy investors appear to have meaningful choices to make. However, financial markets are seldom so straight forward and these choices increasingly seem to be muddied by a rising trend in volatility, which is leading to a disturbing rise in the risk of contagion.

Take for example the recent collapse in international oil prices. Many economists consider this to be an unequivocal boost to global growth as disposable incomes increase as inflation falls, thereby supporting a sustainable rise in consumption. Ordinarily you might therefore have expected this to be supportive of risk assets and yet all it has done is heighten investor risk aversion. As a result the increase in oil price volatility has led to a near doubling of volatility in fixed income yields, a pick up in equity market volatility and marked movements in a variety of key foreign exchange rates.

One explanation for this is this is a by-product of excessive policy stimulus by western central banks leading to financial markets in general no longer looking compellingly cheap and yet consensus continuing to back risk assets turning them into a ‘crowded trade’ with little margin for error. But why is this so? Primarily because of the herding of investor behaviour by central bankers.

Central bankers across the world have provided investors with ‘forward guidance’ tobuy risk assets. Investors have consequently bought with gusto, and often by many who can ill afford to take such risks. But who will wear the consequences if/when it goes wrong?

Almost inevitably the investor, as the central banker will have dusted off the excuses, or perhaps even moved on, by the time things turn out different to what was originally forecast. Consequently an awareness of and preferably an avoidance of crowded positioning is necessary in constructing a well balanced and diversified portfolio.

But the questions remain, how much of this is a normalisation in volatility, which has been abnormally low for an extended period of time, and how much of this is an elevation in the risk of contagion? The two are extremely difficult to separate, made worse by the internationalisation of capital markets, high frequency trading, and the increased use of index proxy structures (especially ETFs), which feed on themselves on the way up and devour themselves on the way down as the tide of liquidity goes out. Therefore with the US Federal Reserve no longer pursuing outright Quantitative Easing it appears that the cap on volatility has finally been lifted and with it an increasing risk of contagion, which central bankers are at risk of struggling to control no matter what supportive words they care to utter.

Consequently now that the system has been buoyed with excess global liquidity the risk is that a rise in financial market volatility will lead to a rise in the possibility of contagion. Policy makers have raised the contagion stakes having ‘guided’ investor expectations, and woe betide if they now fail to deliver. What’s more, so far results have disappointed owing to weak global growth and inflation missing its target. As the economist Rudiger Dornbusch commented “in economics things take longer to happen than you think they will, and then happen faster than you thought they could”, so never underestimate the power of the markets to catch you unaware.

The take away therefore is to mitigate the risk of falling victim to increased volatility and contagion. This is best done by applying some conventional well tested rules such as avoidance of over concentration, geographical as well as asset class diversification, and a close inspection of maximum historical capital loss by risk grade to ensure that the selected portfolio aligns with the client’s attitude to risk and capacity for loss.

Thankfully all of which are core features of Parmenion’s range of investment solutions.

Key foreign exchange rates:

US 5 Year Treasury Return

Equity Market Volatility

Sterling Foreign Exchange Rates