Why it is still all quiet on the Western front

Erich Maria Remarque’s All Quiet on the Western Front is one of the best-known anti-war novels (and films) as it outlines how German soldiers in France suffered physically and mentally in the trenches (and, ultimately, even once the defeated survivors had returned home).

All the troops want is a peaceful, quiet life and no doubt many advisers and clients would share that sentiment, especially with their portfolios in mind. One of the most startling features of the global equity markets (or at least developed ones) is just how calm they seem to be and history shows this tends to be a good thing, although there do seem to be four clear ‘cycles’ when it comes to market volatility:

  • A period (often lengthy) of total calm, where headline indices do not gyrate, as they make steady, consistent upward progress.
  • A period where the first doubts about the bull market creep in, sellers begin to challenge buyers with the force of their opinions and headline benchmarks make progress but at a lesser rate and with greater effort. Ultimately, this proves too much for nervy buyers and holders, who crack and start to sell.
  • A period where doubts finally give way to panic. Volatility becomes the norm as share prices and indices gyrate wildly, but with a clear downward bias. Finally, the wet towels come slopping into the ring as buyers capitulate and turn seller at almost any price.
  • Markets bottom amid this final frenzy. Calm descends as buyers begin to regather their nerve as they find assets that are once more attractively valued, and markets begin their next march higher.

It is not hard to work out where we are now.

  • In the USA, the S&P 500 has moved by more than 1% from open to close on a daily basis just 33 times in 2018 to date. While that is an increase on 2016’s soporific count of just eight times, it leaves the US on track for its quietest year, using this benchmark, since 2006.

US equity markets continue to benefit from a prolonged period of calm

Source: Thomson Reuters Datastream

  • In the UK, things are a little livelier, but not much. Thirty-six open-to-close gains or falls of more than 1% in a day again exceeds 2017’s lowly tally of 17 but leaves the FTSE 100 on track for its most docile year since 2005.

The FTSE All-Share is also quiet even if it is finding it harder to make further gains

Source: Thomson Reuters Datastream

So, the questions now are why is trading so torpid? And will it continue?

After all, the good news is that volatility is spookily low as that has tended to be good for equity returns.

But low volatility could be bad news, too. The charts above also suggest that unusual calm leads to unusual risk-taking which leads to over-exuberance, poor capital allocation and eventually volatility’s return with a vengeance as poor (or simply over-valued) investments falter and confidence finally cracks – even if we all know the past is no guarantee for the future.

Cooling dose of cash

It does seem odd that stock markets should be so calm, given America’s tariff attack on its largest trading partner; the US Federal Reserve’s determination to increase interest rates and withdraw Quantitative Easing; a bubbly oil price; a stronger dollar; surging global indebtedness; and the cracks that have already appeared in riskier arenas such as cryptocurrencies, emerging/frontier markets and richly-valued technology stocks.

Perhaps those cracks explain why more developed Western markets are holding up, as money retreats from the periphery to the core and to a narrowing selection of assets, geographies, sectors and stocks that are perceived to be ‘safer.’

Equities also appear to be taking the view that central banks still have their back as cheap liquidity leaves oceans of cash sloshing around looking for a decent (risk-adjusted) return – and many market participants may still favour stocks, given the lowly interest rates available on cash and the historically modest yields offered by (Western) government, corporate and high yield bonds, relative to the risks involved.

It is easy to see why, looking at how the balance sheets of the US Federal Reserve, European Central Bank, Swiss National Bank, Bank of England and Bank of Japan have swollen since 2008 thanks to the QE, asset-buying schemes.

The big five central banks’ balance sheets are about to start shrinking

Source: Bank of England, Bank of Japan, European Central Bank, FRED - St. Louis Federal Reserve database, Swiss National Bank, US Federal Reserve

Every time they have tried to ease back on the stimulus, stocks (and even economies) have wobbled and central banks have turned the taps back on, providing the liquidity in which asset valuations could bathe.

Perhaps the test then will come in 2019, as the Fed sterilises QE all the faster and the Bank of England and European Central Bank stand pat, with the result that liquidity will be withdrawn on a net basis.

And if that is accompanied by greater equity index and share price volatility, that could be one early warning signal that advisers and clients might like to ponder.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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