By: BlackRock Investment Institute (BII)
- Last week’s selloff is a reminder of the potential for late-cycle bouts of volatility. We remain risk-on, yet advocate maintaining portfolio ballast.
- The U.S. increased tariffs on $200 billion worth of Chinese imports, dialing up pressure on China as the two continued their trade talks.
- Energy ministers of key oil producing countries will meet this week amid rising tensions in the Gulf.
Lessons on low market volatility
A selloff in risk assets last week – driven by fading expectations for a U.S.-China trade deal – has shattered the calm after a prolonged period of low market volatility in 2019. We remain cautiously pro-risk, but see potential for further bouts of volatility in this late-cycle period. This argues for maintaining ballast in portfolios.
Chart of the week
Cross-asset implied vol by asset class, 2005-2019
Sources: BlackRock Investment Institute, with data from Bloomberg, CBOE, Bank of America Merrill Lynch, and JP Morgan, May 2019. Notes: We use the CBOE VIX Index, MOVE Index and JPMorgan Global FX Volatility Index to represent the implied volatility in equities, fixed income and currency markets respectively. A z-score of 1 means the volatility level is one standard deviation above the cross-asset vol average for the period from the start of 1990 to May 8, 2019. The cross-asset vol is calculated as the average of the z-scores for the three asset classes. We omitted the peak of the volatility spike in late 2008 and early 2009 during the global financial crisis, in order to better present the trend for the rest of the selected period.
The market outlook had become more benign this year, following a selloff in the last quarter of 2018. Cross-asset implied volatility – a gauge of volatility across the equity, fixed income and foreign exchange markets – recently dropped to near record-low levels. See the chart above. Volatility in the currency markets has been particularly low, dragging down the average level across different markets. The backdrop behind low vol: a potential prolonged holding pattern by key central banks – most notably the Federal Reserve – coupled with a slowing but still growing global economy. Yet earlier last week market volatility spiked, after U.S. President Donald Trump’s tariff threat on China upended the expectation for an imminent trade agreement. The VIX Index, a gauge of the U.S. stock market volatility, jumped to the highest level since late January.
Reasons for caution
Last week’s market moves serve as a reminder that unusually low levels of market volatility likely do not accurately reflect the risks in this late-cycle period. Geopolitical risk is a key example. The market’s attention to global trade tensions – as reflected in chatter about the risk in analyst reports, traditional and social media – had dropped sharply from the peaks in mid-2018, our BlackRock geopolitical risk indicator (BGRI) shows. This was pointing to greater potential for market volatility should the risk flare up, as it has over the past week. We could still see a U.S.-China trade deal that includes a Chinese pledge to purchase more U.S. goods, among other items, yet implementation and enforcement will be challenging, in our view.
We still favor risk assets, given the ongoing global economic expansion and the prospect for central banks to stay accommodative. Yet macroeconomic volatility is increasing in this late-cycle period, reflected in the rising dispersion of analysts’ GDP forecasts. Our research suggests periods of rising macro volatility have historically featured greater market volatility. To be sure, we see major central banks on hold in the months ahead, providing a stable policy backdrop. But U.S. growth is slowing and economic data could become more noisy in the months ahead after a sharp inventory buildup in the first quarter. Another potential source of volatility: In China, we see signs of a growth recovery, but the scale and longevity of the government’s stimulus package may soon be called into question.
Bottom line: Recent spikes in market volatility remind us a balanced approach is key to investing in the late-cycle period. We still see a narrow path ahead for risk assets to move higher – but there are risks that could knock markets off track. U.S. government bonds have historically played an important role in cushioning portfolios against such bouts of volatility. In equities, we favor the U.S. and emerging markets, with a focus on quality companies that can sustain earnings growth even in a slowing economy.
Week in Review
- The U.S. raised tariffs on Chinese imports worth $200 billion as the two sides continued negotiations to resolve their trade dispute. China threatened to retaliate but stopped short of giving details.
- Global stock markets dropped to six-week lows. Perceived “safe haven” assets benefited, with U.S. Treasury yields declining and the Japanese yen hitting the highest level in more than six weeks.
- U.S. consumer prices data was slightly weaker than expected, supporting the case for the Fed to remain on hold for the time being. Europe’s economic activity data indicated that the area’s economy might have bottomed out. Germany’s industrial output rose more than expected in March, though industrial orders disappointed.
Weekly and 12-month performance of selected assets