After a few years of relative calm, market volatility has picked up over the past year, moving back in line with long-term averages. And though markets may have quieted down a bit over the last couple of weeks, there’s likely more turbulence ahead in 2016.
Market watchers have thrown out many theories to explain this elevated volatility across asset classes, but in my opinion, these market myths aren’t the real explanation. Here’s why.
Myth #1: Bond market illiquidity
Some have cited the possibility that recent market volatility may be due to reduced levels of bond market liquidity. The evidence doesn’t support this claim. Clearly, there are sectors where fixed income liquidity remains challenging (the high yield energy-sector, for instance), and there are always times when some spread markets are less liquid and distressed. However, this sector-specific illiquidity often has to do with idiosyncratic risk specific to those market segments as well as investor risk aversion. It doesn’t mean there’s an issue with liquidity in bond markets overall.
This is evident when you look at average daily trading volumes (ADV) for several significant segments of the U.S. bond market, a decent proxy for overall liquidity. Trading volumes for many of these segments seem to signal very good liquidity. For instance, the ADV of 10-Year Treasury futures contracts has accelerated to roughly $149 billion in 2016, 60 percent greater than last year’s average, as the chart below shows.
Meanwhile, according to Credit Suisse data, the mortgage market recently witnessed an ADV of $48 billion in February, the highest level in more than a year. Even the cash-traded corporate credit markets, which can be an area of liquidity challenge, saw ADVs improve meaningfully in February. Of course, liquidity is always a concern, and there are areas of stress in markets, but overall market volatility isn’t a reflection of generalized bond market liquidity trouble.
Myth #2: Oil price movements
The assertion that markets are being driven higher and lower primarily on the back of oil price moves is grossly overdone. Case in point: Over the past several months, the Los Angeles Lakers basketball team’s winning percentage has often held a tighter correlation to risk-asset market moves than oil prices, according to BlackRock research. And even if this weren’t the case, correlation doesn’t imply causation, or even a particularly meaningful relationship. Markets are too complex for simple arguments of this kind.
Finally, while oil price declines clearly impact the credit quality (and default probabilities), earnings potential and equity valuations of energy sector high yield firms, I believe their impact on daily market gyrations is overstated.
The real explanation
I believe structural transformations to the world economy, namely changing demographics and profound technological innovations, are the forces behind recent volatility and asset valuation dispersions. Indeed, these important big picture trends, which I’ve written about many times before, help explain some of the major risks to markets and the global economy today.
For instance, the risks of escalating tensions in the Middle East, of economic disruption out of China and of slowing U.S. and global economies are each largely a function of changing technology and demographics.
Take the risk of a worsening Middle East crisis. It’s possible that oil prices are finding a new lower range that may be capped on the upside by advances in extraction technologies and changing demand requirements. The potential disruptive impact of this new lower range on Middle Eastern countries’ current account positions raises the risk of escalating tensions in that region.
At the same time, perhaps the most pivotal fault line of risk in the world today is the stability of China’s economic system, as policy makers there attempt to transition from a manufacturing/export-led model of growth to a more consumer-driven/services model reflective of today’s high-tech world.
Finally, the potential slowing of the U.S. economy — another major risk — has a lot to do with the limited ability of monetary policy to address structural hurdles facing the U.S., like an aging population and a labor force not fully trained with the necessary skills to work with today’s (and tomorrow’s) technologies.
The bottom line: Stepping back to see the real forces at work is vital in a world of complex market crosscurrents, and too narrow of a focus may be part of what leads many to underperform.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog.
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