Many investors are bracing themselves for turbulent markets in the weeks ahead. Heightened political and policy uncertainties surely could send volatility up. But we would see any market weakness as a buying opportunity, as underlying economic trends point to a sustained low-volatility regime that we believe favors equities.
Equity markets are in a jittery mood. A commonly used gauge of U.S. equity market volatility—the CBOE Volatility Index (VIX)—has posted daily moves of 30% on two of the past 10 days. The put-call options ratio—a measure of investor sentiment—confirms the nervousness. The ratio of open interest on put options versus call options for U.S. stocks (blue line) has climbed to levels last seen in the late-2015 market sell-off, as seen on the chart, signaling that more investors are seeking downside protection. The put-call ratio on German stocks (green line) has also risen.
Economy is key
Investors are looking toward a confluence of events over the next few weeks that could raise volatility: First, a fractious U.S. Congress needs to agree on a budget for fiscal year 2018 by the end of September and raise the so-called debt ceiling that limits government borrowing. Second, the Federal Reserve is about to embark on an unprecedented winding down of its crisis-era balance sheet. This coincides with a European Central Bank readying to scale back its asset purchases. Third is a potential flare-up of U.S.-North Korea tensions.
The worries come at a time when volatility is low across the board—both in markets and the economy. For example, the five-year rolling realized volatility on the U.S. Consumer Price Index (CPI) dropped to a record low in July. The U.S. budget showdown is now top of mind. We see a temporary Band-Aid budget and a raising of the debt ceiling. Yet a frayed relationship between the White House and Congress—and little scope for bipartisan collaboration—increases the potential for upsets such as a temporary government shutdown. Such events have sparked volatility in the past, but had no lasting impact. Central banks will proceed cautiously in removing monetary accommodation, we believe. And our base case on North Korea is the U.S. pursuing its “peaceful pressure campaign”—using sanctions, with the help of China, to pressure North Korea to denuclearize.
Bottom line: We view any near-term uptick in volatility as short-lived and a potential buying opportunity, unless political events materially dent business and consumer confidence. Today’s backdrop of sustained economic expansion favors risk taking, we believe. We prefer equities to fixed income in this environment.
Read more market insights in my Weekly Commentary.
Listen to Richard Turnill and Jeff Rosenberg talk about BlackRock’s midyear investment outlook on the inaugural episode of our podcast, The Bid.