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By Christine Benz | 10-18-2017 02:00 PM

3 Reasons Volatility Is So Low

Luck, strong fundamentals and a policy cushion have kept markets placid, says Vanguard economist Roger Aliaga-Diaz.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Amid a placid and high-returning market, many investors are wondering how long it could last. I recently sat down with Roger Aliaga-Diaz, chief economist and principal in Vanguard's Investment Strategy group, to hear Vanguard's take on low inflation, low market volatility, and the firm's expectations for future equity returns.

One of the big puzzles for people who look at the markets is why volatility has been so low despite geopolitical concerns and other things that might in the past have caused volatility. Why do you think the markets have been so very placid?

Roger Aliaga-Diaz: That's a great question. It's not really a coincidence that volatility is low when markets are rallying. In the past we have seen that long stretches of high market returns are accompanied by low volatility. As you say, what is really baffling right now is that this is happening in the midst of number of geopolitical events, domestic political events. In part, what is happening is that that type of political uncertainty is not translating to the market uncertainty that affects investors.

I would say that there are three reasons for that. One is luck, in the sense that some of the worst-case scenarios, some of the political movements we've been hearing about, and even some of the policy movements like the Fed moving to a new tightening cycle, have not resulted in more the more extreme case scenarios that people feared and anticipated.

In some other cases like Brexit, for example, they haven't been resolved yet. It's almost like the resolution has been kicked out far in the future enough for the market not to be concerned too much about that. So that's a little bit of luck in that sense.

The other thing is fundamentals. Regardless of luck, the the global economy has been strengthening continuously through the last three, four years, improving. Right now we see basically strong fundamentals. It's the first time we've seen a forecast for economic growth globally being revised up rather than down. We see the whole deleveraging process in the case of households is almost complete in the U.S. This is way far along in Europe. Global markets have full employment for the most part. As we go through various economic indicators we see the fundamentals have remained strong.

The last reason, I think, is policy cushion. The fact that these unconventional monetary policies were aimed in some sense to sustain asset prices and markets. I would say it's not just a purchase of bonds through QE, it's almost a signaling that central banks have been continuously giving to markets about the commitment to be there, the "whatever it takes" approach of monetary policy, but actually applies to any other central bank, too. That has helped, certainly, to cushion periods of market crisis, such as when we saw the Chinese equity market tanking and the Fed delaying the rate hike that year. Not much of a connection there between the domestic equity market in China and the employment and inflation in the U.S., but the Fed did react to that. It's a good example how central bankers have been sensitive to global events like those.

Benz: OK. I guess you would say though that it would be a mistake to extrapolate currently low volatility out into the future, that there could always be something that could derail this confluence that has kept volatility quite low.

Aliaga-Díaz: Yes, it's certainly something that we're actually kind of focusing on now. We are entering, in some sense, a period of normalization of monetary policy. You could think that this policy cushion is going to be slowly and gradually removed from the scene--that's the intention of the Fed certainly, but the ECB may not be far behind and even the Bank of England, too. We may see what we call a recoupling with fundamentals of the markets, coupling of markets with fundamentals, and we may see a little bit of more volatility. Not necessarily something bad, it's more of healthy type of volatility, but certainly we could be entering a period in which that policy option is not available anymore.

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