JPMorgan Has a Surprisingly Simple Theory for Low Volatility

  • Low level of economic surprises, fewer active investors
  • Leverage among individual U.S. investors is still "extreme"

Trump, U.K. Election Risks Shaken Off by Markets

A slew of terrorist attacks in Europe, geopolitical strife from the Middle East to Asia, U.S. policy uncertainty.

Investors have conjured up myriad theories to make sense of historic lows in market volatility across asset classes despite such strong headwinds, citing everything from soaring assets in passively-managed vehicles to the rise of social media.

To explain the tranquility, JPMorgan Chase & Co. strategists led by Nikolaos Panigirtzoglou go back to the basics. The subdued measures are an accurate reflection of economic and market fundamentals, they argue.

"A very low supply of economic surprises currently is by itself enough to explain the low level of market volatility," the strategists write in a recent note to clients.

Here’s the argument: volatility stages an uptick when market participants shift positions due to changes such as the release of economic data or a central-bank policy decision that alter the outlook for inflation and growth. The sensitivity to such surprises, in turn, is largely shaped by two factors: the extent to which positions are levered -- if market players are awash with cash, they have the financial firepower to buy the market dip, and cap price moves in either direction -- and the propensity of investors to trade.

On all three fronts, tranquil market conditions are vindicated by economic and market fundamentals, according to the U.S. bank, dispelling fears that historic lows in cross-asset volatility are indicative of investor complacency.

The strategists look at the size of revisions to global growth forecasts made by the bank’s analysts as a proxy for macroeconomic surprises generally, and overlay this with implied market volatility levels across rate, credit, equity, currency and commodity markets. The result: economic surprises and volatility move in a "remarkable" lockstep, according to the JPMorgan team.

JPMorgan Chase & Co.

"Given the market reaction to Brexit and more recently, Donald Trump’s unexpected presidential victory, perhaps investors have learned that it pays to resist overreacting to political developments," said Neil Dutta, head of U.S. economics at Renaissance Macro Research. "Economic volatility is as low as it has ever been. Why wouldn’t market volatility be?"

Investors may have been justly lulled to sleep by a stream of steady economic data. But there’s one big caveat: the buildup of leverage among individual U.S. investors that’s reached "extreme" levels amid the market calm, according to JPMorgan’s team. As a share of the S&P 500’s market capitalization, the amount of credit used to finance the purchase of stocks is approaching near-record levels last seen in mid-2015, shortly before the unexpected Chinese devaluation of the yuan.

A bevy of structural changes augur well for the low-volatility environment to endure, JPMorgan team reckons. For instance, turnover in fixed income and equities is being dampened by the increase presence of central banks and passive vehicles in those asset classes, which in turn weighs on volatility.

What’s more, the global financial system is awash with $5 trillion of excess cash, as measured by the difference between M2 money supply globally minus an implied demand target developed by the strategists.

"Equally important as a long-term depressant of market volatility is a persistently high amount of excess cash balances by non-bank investors globally, which in our opinion backstops both equities and bonds, and reduces downside volatility," the JPMorgan strategists wrote.

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