Market GPS: Out of the Goldilocks Zone?

Could 2020 mark the beginning of a new era of volatility for global markets? David Elms, Head of Diversified Alternatives, gives some insight into where he sees areas of opportunity in the alternatives asset class and what this might mean for investors.

Key Takeaways

  • Despite global stresses, volatility remained low through 2019. Heading into 2020, we expect to see increased volatility for both equity and fixed income markets, given the prevailing levels of political and economic risk.
  • We expect a more significant resetting in markets at some point, which may provide an opportunity to buy positions that should react positively if risk premia widen and volatility spikes, which usually coincides with sharp market falls.
  • In this environment, the most important role an alternatives strategy can play is to deliver an attractive return with little or no correlation to the sources of return driving performance for traditional assets.

Where do you see the most important opportunities and risks in 2020?

Contrary to expectations, most asset classes swooned in 2019 and volatility, as measured by the Chicago Board Options Exchange (Cboe) VIX Index, remained stubbornly low, ignoring global stresses. However, certain factors threatened to burst this particular bubble. Government protests, inverted yield curves and negative rates rattled investors, and unicorns (startup companies with a value of more than $1 billion) disappointed or failed as reality took hold.

I continue to hold the view that volatility is underpriced. It seems inevitable that we will see increased volatility for both equity and fixed income markets in 2020, given the prevailing levels of political and economic risk. From Brexit uncertainty and a highly contentious U.S. presidential election to rising populism and further twists in the U.S.-China trade conflict, the range of factors at play leads us to believe that the potential for large moves in the market has been underpriced.

Artificially low volatility has been underpinned by an extended period of easy fiscal and monetary policy, with trillions of dollars of stimulus from the U.S. Federal Reserve, European Central Bank and the Bank of Japan. Many of the lessons that should have been learned from the Global Financial Crisis have been ignored in lieu of sustaining the status quo (i.e., kicking the can down the road). Meanwhile, the leverage effect has fueled the price of risk assets, benefiting equities, and put a cap on interest rates, to the benefit of bonds.

In this environment, the most important role an alternatives strategy can play is to deliver an attractive return for investors, with little or no correlation to the sources of return driving performance for traditional assets.

Which key themes are particularly relevant within the alternatives space?

Diversification is an overused axiom of financial markets, but as the sharp drawdown we saw in December 2018 shows, true diversification is hard to deliver. During periods of increased market stress,

price movements from seemingly uncorrelated assets can often synchronize. The question for alternatives in 2020 is whether the asset class can deliver truly diversified returns for investors.

Markets right now are as intractable a problem as the classic Gordian knot, displaying a bizarre combination of highly elevated political and economic risk, which at the moment is not reflected in prices. We see potential signs for further uncertainty ahead, but timing the market is virtually impossible.

Is there a particular chart to watch as a key indicator for change in 2020?

The VIX Index is close to its 10-year average, giving us an interesting insight into current expectations for market volatility. We do not believe that markets will tread water in the months ahead. We expect a more significant resetting in markets at some point, which may provide an opportunity to buy positions that should react positively if risk premia1 widen and volatility spikes, which usually coincides with sharp market falls.

VIX Volatility Remains Persistently Low

Source: Chicago Board Options Exchange (Cboe), Thomson Reuters Datastream, 8/31/07 to 11/30/19. The VIX is a calculation designed to provide a measure of constant 30-day expected volatility in the U.S. stock market, derived from prices of stocks listed on the S&P 500 Index and put options.

Which market trends should investors
watch in the year ahead?

1Risk premia refers to the amount by which the return of a risky asset is expected to outperform a risk-free asset.