The Return of Market Volatility

“Delightfully still” or “gently sparkling,” that is the choice that Hildon offers its water drinkers in the United Kingdom (photo). It is also what, to the delight (and profit) of many investors around the world, markets have delivered for much of the last few years. And it is what’s now increasingly threatened by a combination of factors.

The unusually low market volatility of recent years, both implied and realized, has encouraged greater portfolio risk-taking, especially when it comes to carry trades. Relatively limited market fluctuations have contributed to the levering of traditional asset classes, as well as greater cross-over investor interest in more exotic ones. And, with the notable exception of May-June 2013, the approach has worked remarkably well.

The suppression of volatility has been driven by a combination of economic, policy and technical reasons – namely, a subdued economic “Goldilocks” in which growth is stuck in a low-level equilibrium; central banks pursuing a policy stance committed to repressing volatility lest it undermine a much-hoped for (and frustratingly elusive) economic lift-off; and lots of cash on the sidelines willing to quickly buy the dips.

Two of these factors are under increasing pressure; and, if current trends continue, the third one could also be in play at some stage – all of which would contribute to the sustained return of larger market fluctuations.

Economic growth in both Europe and the emerging world is threatened by geo-political and socio-political factors, such as tensions in Ukraine and protests in Hong Kong. Meanwhile central banks are no longer acting in unison: The Bank of Japan and the European Central Bank are under pressure to be more accommodating while the Federal Reserve is in the process of gradually easing its foot off the accelerator. Should these factors intensify, both corporates and households could become less predictable when it comes to quickly releasing cash from their balance sheets and into financial markets.

You need only look at recent developments in the currency and commodity markets to get a feel for these changes – be it the movements of the Euro and Yen versus the dollar (a reflection mainly of the new multi-track world of central banking), or the increasing number of individual commodities nearing or in bear market territory (driven primarily by sluggish global growth).

Especially when compared to bonds and stocks, these two asset classes are further removed from the direct influence of central banks and sidelined cash. As such, they respond more quickly (and more fully) to movements in fundamentals and policy differentials. They are also more likely to induce pro-cyclical behavior and, as such, initial price movements can be easily amplified.

Hildon will continue to offer its clients a choice between “delightfully still” and “gently sparkling” refreshments. It is a lot less clear whether markets will be able to do the same when it comes to price volatility.

Mohamed A. El-Erian is the former CEO and co-CIO of PIMCO. He is chief economic advisor to Allianz, chair of President Obama’s Global Development Council, and author of the NYT/WSJ bestseller “When Markets Collide.” Follow him on Twitter, @elerianm.

Photo: Mohamed El-Erian