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Financial Industry Insights from Advisors Asset Management

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The Hatfield and McCoy of Volatility

Volatility and its dormancy for the last year has awoken to a consensus trade that was heavily overweight short volatility. The reasons are plenty as to why now, and we will put this into a fundamental context at the bottom, however, we feel volatility – like currencies – is best viewed in pairs for context. What we find is the bond and equity volatility is very much like the feud between the Hatfields and McCoys.

Though correlation of asset classes can ebb and flow with liquidity flooding and droughts, using bonds relative to equity volatility brings about a historic measure. Below we measure the volatility of the U.S. Treasury market to that of the equity markets and the all-time low being set at the open of the markets today, February 6, 2018.

The circles denote a point where the ratio dropped to two standard deviations below its long-term average. As we have noted, so many events in the markets see a reversion to the mean after a two-sigma print, so we continually look for said metrics.

The main question is, “What happens from here?” To get an understanding, consider what happens in the following equity and bond markets in the 12 months following a volatility ratio below two standard deviations wide.


Source: Standard and Poor’s, Bloomberg, Barclays

What we know is that clients have been more fearful than they should have been over the last decade by balance sheet repair, cash build up, underweighting equities and investor sentiment indicators in general. When we try to put a risk/reward in a very simple frame, one finds that the two best areas to be in for volatility adjusted return are municipals and Treasuries. Considering that municipals are expected to have a negative net supply this year (our estimates is for negative 125 billion) versus Treasuries, which we believe will see large issuances to fund deficits. Municipals look like the better choice for those more cognizant of risk. For further information, review our 2018 Investment Outlook. For those with larger risk appetites and willing to look at wild swings in headline and pricing risk, high yield and equities have the highest average performance.

We still see fundamental strength in the overall economy and the correction is healthy in nature. Corporate earnings are projected higher from the outset, a bullish sign not seen in some time. The average Purchasing Managers Index (PMI) of the larger countries across the globe is averaging 54.5 and the ISM services employment measure came in at its all-time high. Fiscal stimulus is going to give a boost to consumption and GDP throughout 2018 which should help offset a more hawkish Federal Reserve. The correction may have a bit more bite to it as the computer-based trading and high anxiety fuel a bit more risk off, however, long term the investor who buys on weakness and holds for the duration generally does the best.

 

CRN: 2018-0202-6395 R 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.