A few weeks ago, we discussed the very low levels of stress showing up in the various Federal Reserve and Conference Board financial system indicators. Digging deeper and looking at some of the individual indicators of risk-tolerance and volatility out there in various markets produces some very interesting observations.
Since we spend our time investing in the global equity markets, we’ll take our first quick look at volatility in the S&P 500 and the MSCI EAFE equity indices. The charts below show that market volatility is back at multi-year lows, hence explaining why the VIX in the US is trading at multi-year low levels. We use the standard deviation for the trailing 20 days of index performance. In the S&P 500, realized volatility has reached the lowest sustained levels observed since early 2011. The EAFE has achieved a much more significant milestone. 20-day volatility in the MSCI EAFE hasn’t been at these levels since May 1996!
What happened the last time volatility got this low? The 2011 episode, of course, morphed into a massive correction and spike in volatility in August of 2011 as the European financial crisis and S&P US debt downgrade crisis took hold. In 1996, the EAFE subsequently corrected just south of 10%, with the correction low achieved in early 1997. The market correction lasted nearly a year. In both of those cases, markets eventually resumed strong upward trajectories. Prior to 2011, the last sustained round of low volatility at these levels occurred in April 2007, just before the global financial crisis began brewing. We don’t want to make any alarming market calls, especially since many of the other indicators we follow show a much better backdrop than the environment confronting markets in April 2007. Nonetheless, we would not be surprised to see this market take a corrective breather in the near-term.
Our next look comes from the world of high-yield bonds. We like to look at the spread between the Bloomberg High-Yield Index and 10-year US Treasury yields. When this spread is trending down and compressing, it’s an indication that flows into the riskier end of the debt pool are strong and, hence, risk tolerance is higher. This week, the spread has compressed to the lowest level observed in our data series, which goes back to 2002. Yes, depending on the indicator, high yield spreads have now equaled or eclipsed the levels observed in early 2007 on the downside. The global chase for yield has certainly been a formidable force. Anecdotes in the business press continue to pour out about the reemergence of cov-lite loans and PIK bonds and the like.
Does this mean the world is about to come to an end? Not necessarily. As you can see below, during the last cycle, spreads first reached super compressed levels in late 2004 and stayed benign for approximately three years before the wheels came off the debt (and equity) markets and spreads spiked to record levels. As we mentioned above when discussing equity volatility, the general indicators we like to use present a better backdrop than observed in early to mid 2007, when indicators were clearly showing recession probabilities were high and that long-term momentum was waning in various areas across the investment universe. But, we’ll say again, we wouldn’t be surprised if there’s some sort of corrective activity in these markets to keep participants on their toes in the near future.
We’ve said on several occasions over the past year and a half that the overall intermediate-term market backdrop remains favorable worldwide, especially in overseas markets. There’s nothing at present that materially changes our intermediate-term view. However, corrections are a part of life in equity markets and other markets and serve to reset investor expectations in a healthy way. Indicators like the ones above show that a reset may be in order in coming weeks and months to recalibrate risk markets that have become very complacent. Of course, we’ll keep an eye on the longer-term trends. If anything changes underneath the surface worthy of changing the intermediate-term outlook, we’ll certainly shout it from the rooftops.
