ANNUAL MACROECONOMIC AND VOLATILITY STRATEGY REVIEW
Every year Dominicé likes to welcome its investors to the Annual Volatility Strategy Lunch Presentation. Over 100 investors gathered in Geneva and Zurich this January to hear Dominicé’s insights relating to the current macroeconomic environment, as well as giving its volatility strategy review and outlook.
Dr. Michel Dominicé, Senior Partner, presented his view that we are transitioning into a new equilibrium – zero interest rate capitalism. Defined by persistent low to negative real interest rates stemming from demographic changes and technological advances, zero interest rate capitalism found its genesis in the 1980’s. Japan, due to its aging population, is an early example of transition into this new equilibrium characterized by low nominal interest rates coupled with low inflation. The rest of the world did not take long and has been catching up over the past decade.
Up to the late 1980’s, governments were particularly concerned with taming inflation. One of the methods for managing inflation was the manipulation of the money supply, as there was a strong correlation between the increase in the supply of money and inflation. This relationship has broken down since then. In the current zero interest rate regime, governments have been particularly concerned with increasing inflation. However, an increase in the money supply has helped little in this regard. This is mainly because low capital returns encourage investors to increase their cash holdings.
Such an environment, accompanied by the lowest volatility seen in 50 years, raises the question: is this persistently low market volatility due to zero interest rate capitalism or is it a part of a classic volatility cycle? Mr. Dominicé argues that current low volatility is not likely to be linked to zero interest rate capitalism, but is rather cyclical. Record low S&P500 volatility was observed 3 times over the past 50 years – in 1965, 1995 and 2017. These events have several points in common: they occurred after years of bull market, valuations were not extreme and markets continued their upward trend for some time thereafter (in 1965 and 1995). We may therefore expect the bull market to continue for some time, defined by rising volatility and recurring market corrections, as we now enter the “bubble phase”. However, we do not believe that we are in an endless bull market. Once zero interest rate capitalism triggers a major asset re-evaluation, equity valuations gradually become unsustainable and volatility increases and then equity markets will be ready for a potentially severe bear market.
Pierre de Saab, Partner and Head of Asset Management, further analyzes the reasons behind the low volatility regime. Rallying equities, positive and stable macro fundamentals, volatility supply and gamma hedging, as well as low stock correlation, have all contributed to record low volatility. However, Mr. de Saab points out that even though volatility is low, it is not cheap. Volatility premiums are reasonable and the opportunities to profit from volatility are still there. It is nonetheless important to be prudent in choosing volatility strategies for one’s portfolio and to carefully analyze the risks and the value added to the portfolio. Some of the most profitable volatility trades over the past year meant taking directional market risk, which in turn could be a liability in case of a market downturn. With the bull market continuing to rally, hedged and defensive volatility strategies could be an appropriate solution to diversifying the portfolio.
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