1990s Redux: Volatility may be back

(September 2006) In the 1990s, investors and advisors, out of necessity, learned to be Fedwatchers. The unexpected rise in interest rates in 1994 hammered bond funds. An observation on “irrational exuberance” by U.S. Federal Reserve chair Alan Greenspan in 1995 precipitated a market pullback. Currency shocks in 1997 and 1998 made U.S. Treasury bills a safe haven, while the U.S. Federal Reserve had to stickhandle between the threats of inflation and recession.

So when, in the late 1990s, Greenspan said that such innovations as “just-in-time” delivery might have put a permanent dent in the labour pressures firms traditionally faced, many investment counsellors breathed a sigh of relief: The Fed wasn’t going to choke off economic expansion by putting the pedal to interest rates just because labour markets looked tight.

Except, in the end it did, until interest rates started to fall in 2001. In the interim, stock markets settled down, but historic volatility was much reduced.

Now that central banks are approaching a neutral interest rate and reaching the end of their tightening cycle, observers wonder whether there will be a renaissance of volatility. The place to look is emerging markets, says a recent note by TD Bank Financial Group economist Richard Kelly, called “Da Vinci’s Other Code: Increased Global Financial Volatility to Come.”

By his account, investment returns have become less volatile — though for the U.S. investor, that means a decided downturn in returns. On the one hand, most international equity markets are now much more closely correlated to the main U.S. equity benchmark, the Standard & Poor’s 500. Comparing the 1995 to 2001 and the 2002 to May 2006 periods, global stocks are now 20% more correlated to U.S. market moves than they were, while emerging markets are seeing a 34% greater correlation.

Oddly, just about every market has done better in the second period than the first, with the exception of the U.S. and China (and the Chinese market has seen its correlation to the U.S. market skyrocket 144%).

But the more important part of the story is that volatility is down 4% across global markets, with some markets such as Toronto and Sydney, experiencing 20% declines — reflected in their continuing, commodity-fuelled expansion. Emerging markets have seen almost a 30% decline in volatility since the 1990s.

To be sure, there are a host of explanations for declining emerging market volatility. Their balance sheets are better than they were during the baht and rouble crises. To some extent, hedge funds seeking to tap higher risk premia have used the carry trade — borrowing cheap money in 0%-interest Japan — to fund emerging market investments. Certainly the premium on emerging market debt is down to near-historical lows: 200 basis points over U.S. Treasuries; whereas in 1998, the spread gapped out from 500 basis points to 1500.

But Kelly prefers to consider a more traditional factor: The interest rate cycle. He notes that, through the 1990s, the highest market volatility came as interest rates where rising, but also during “no-man’s land,” the interim period when it wasn’t certain whether the Fed would continue to tighten, or start to loosen. That was especially true of emerging markets, but also, naturally, of U.S. markets.

As Kelly puts it: “The crucial source of volatility is the end of one of the most stimulative global monetary cycles in history,” adding that, with “future tightening, uncertain markets have become skittish, responding sharply to new information.”

So what do we know now that we didn’t know before? “Before judging new-age arguments for why it’s different this time,” Kelly says, “a look at the largest economy in world reveals an all-too-common-twist — the U.S. did it. Over the last 22 years, volatility in the U.S. market has been nearly 10% higher during the ‘Fedwatching’ stage as interest rates near their peak.” That said, Kelly tries to sort out interest regimes and finds that, “when monetary policy is on auto-pilot, equity returns have been historically low. It is only with the risk of chance that higher returns have been seen.”

Higher risk equals higher return, anyone? Or as Kelly concludes: “Central bankers may be responsible for more drama than we’ve been lead to believe.”

This article originally appeared in Advisor’s Edge Report. Filed by Scot Blythe, Advisor.ca, Scot.Blythe@advisor.rogers.com