Geopolitical Tensions a Prelude to Volatility?
A market rout on Thursday brought to an end an unusually quiet period for financial markets. Early last week, U.S. equities hit new highs, supported by solid U.S. corporate earnings, particularly from financials, and more mergers and acquisitions activity. But on Thursday, rising geopolitical tensions — including the tragic downing of a Malaysian civilian airliner over Ukraine — finally derailed the rally.
By week’s end, large caps had recovered their losses while small caps continued to slip. For the week, the Dow Jones Industrial Average rose 1.09% to 17,100, the S&P 500 Index was up 0.69% to 1,978 and the tech-heavy Nasdaq Composite Index climbed 0.82% to 4,432. The small-cap Russell 2000 Index lost 0.88% for the week. Meanwhile, the yield on the 10-year Treasury dropped from 2.52% to 2.48%, as its price correspondingly rose.
Despite the market swings last week, volatility is still very low by historic standards. This suggests to us that while stocks can move higher, further gains are likely to be accompanied by more volatility.
The Consequences of Complacency
Thursday’s sell-off was significant in at least one way: It was the first time since April 16 that the S&P 500 moved more than 1% in a day. The three-month streak had not been equaled since 1995.
While the spike in volatility was short lived, it was the first time investors have been shaken out of their complacency since April. And as the uptick is coming from historically low levels — the bottom 1% of historical observations — it may have much further to go. Even at its peak on Thursday, equity market volatility, as measured by the VIX Index, only reached 15, roughly 25% below the long-term average.
Low volatility suggests investors are complacent and not taking into account the prospect for bad news. Indeed, there is no shortage of potential triggers for more turbulence ahead.
To begin, geopolitical risk is clearly rising. If nothing else, last week’s tragedy in Ukraine demonstrated that the unrest in the eastern part of the country is far from over. Meanwhile, we are witnessing the continued fragmentation of Iraq and now a ground war between Israel and Hamas in Gaza.
In addition, investors should be mindful of conditions in credit markets. One of the major reasons volatility has been suppressed is linked to the unusually accommodative monetary policy of the Federal Reserve and a very benign credit cycle. Should the Fed raise interest rates sooner than expected and foster a less accommodative regime, that would likely be associated with a further rise in volatility.