Perhaps we were wrong to cite the CBOE's VIX contract as a good indicator of market volatility? Recent events, including on-going military action in Libya and the Portugal sovereign debt crisis, would have suggested that the market should sell off on greater uncertainty, and yet the VIX fell from 29 last week to 17 today. Are investors becoming more sanguine about these issues?
If yes, they shouldn't be. Right now the markets are being assailed on all fronts, with no clear outcome on any of them. Let's take them in turn:
- Japan tsunami: by any standards a large-scale tragedy, in human and economic terms, and, due to the importance of Japanese industry to the global manufacturing supply chain, creating an impact that will be felt around the world. Gross domestic product output will be impacted most heavily in Asia-Pacific region, but there will also be a negative impact in virtually every other economy.
- Geo-political uncertainty (to which we can add oil price hikes): continuing tension in the Middle East affects the entire global economy, by dint of that region's share of global petroleum output. It is by no means clear what the ultimate outcome will be, and in such an environment the oil price risk is on the upside. And readers don't need reminding that the recessions of the 1970s, 1980s and 1990s were caused in large part by oil price hikes. Certainly the sensitivity of the world's economy to oil is much lower in the 21st century, as countries have developed alternative energy sources, but to suggest the price has no significance to economic output is unrealistic.
- Euro-zone sovereign debt crisis: as we noted when it was set up, all the European Stability Fund has done is buy time. Every so often the deeply entrenched structural problems of southern European sovereign debt create yet another crisis (the rise in credit default swap prices recently shows that markets are worrying once again about Irish and Portuguese debt levels, and contagion fears remain rife) and markets sell off on the uncertainty. This issue is not going away…
- Monetary policy tightening: in a time of continuing economic weakness, one would be forgiven for thinking that central bank base rates would continue to stay at their current near-zero levels for the rest of the year. And from its rhetoric the US Federal Reserve still appears to be in this mindset. But once freed from its bottle, the inflation genie is difficult to put back. UK inflation is at 4.4 percent (the “real” number given by RPI is at 5.5 percent), and while we don't expect aggressive hikes, once the Bank of England and European Central Bank start to raise rates, this will result in reduced demand as household budgets are hit due to higher borrowing costs.
These four risk areas all suggest reasons for greater risk aversion in the short- and medium-term.
For investors, it is once again back to “flight-to-quality”, but the impending rise in base rates means that capital value is at risk.
The more sensible flight-to-quality solution is inflation-linked sovereign debt, certainly in the UK and euro zone. With markets pricing in only timid rate rises in 2011 and 2012, one could conclude with reason that inflation will continue to increase before it decreases. Right now, sovereign inflation-indexed bonds are the nearest to a low credit-risk sure-fire thing…
The author is Dr Moorad Choudhry, Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University