With volatility not only so low, but having been low for so long, investors are understandably worried that a return to more normal levels could ruin their summer.
Mike O’Sullivan, chief investment officer for the UK and Emea at Credit Suisse Private Banking & Wealth Management, is nonetheless looking forward to a relaxing summer on the beach – and is allocating accordingly.
‘So much of what we do in our industry has been scarred by the credit crunch,’ O’Sullivan said.
‘Many of us have been conditioned by the high volatility of the financial crisis to think that this will return. We are gripped by the idea of volatility being too low.’
Yet O’Sullivan, who made it into Citywire’s Top 100 in wealth management in 2012, doubts that volatility will leap. ‘At the moment we are living in a volatility desert,’ he argued. ‘We are in a long-term low volatility environment.’
For O’Sullivan, volatility could remain at these low levels for the next 18 months. He noted that if volatility is viewed on longer timeframes, it is the sudden spikes that are the aberrations.
O’Sullivan is confident that volatility will continue to be suppressed by dovish central banks. ‘They will be very cautious before disengaging quantitative easing from the marketplace.’
In particular, he tips US Federal Reserve chair Janet Yellen to be ‘super cautious’, after hints of earlier than expected tightening in her first press conference gave the market jitters.
In the CIO’s view, the Federal Reserve will start to hike rates in early 2015. He adds that equities have risen into such action before then, flattening on a historic basis. That means several more months of upside until the time comes to derisk portfolios.
O’Sullivan accepts that there may be a ‘slowing of macro momentum after the summer’, but believes this will be offset by the potential for additional central bank intervention. ‘Anyone expecting a correction will be frustrated.’
And should there be a slight dip in markets through the months ahead, the CIO relays that he will ‘emphatically’ buy into the weakness.
So what are the implications of prolonged low volatility for investors?
‘It gives us a very different set of investment decisions than if we were in a high volatility market,’ O’Sullivan said. ‘We are still investing in a world where fundamentals matter just a little less.’
O’Sullivan sees several opportunities for exploiting this environment. First, he is long equities in the regions where there is scope for more easing, particularly Japan and Europe. Second, he is overweight in cyclical sectors like technology and materials that tend to outperform in low volatility periods.
Overall, O’Sullivan went overweight in equities in late May, shifting from high yield debt to high yielding shares. He warns that high yield bonds are now ‘becoming quite dangerous’ as valuations look stretched.
More tactically, he shares two trades he has put on for the summer. ‘These can continue to work while you are on the beach,’ he enthused.
One is investing in a basket of stocks identified as acquisition targets. These include companies in industries experiencing significant takeover activity, such as pharmaceuticals, with O’Sullivan also pointing out that healthcare serves as a ‘barbell’ to the cyclical exposure.
Credit Suisse screens the stocks to avoid companies that have blocking shareholders. Those coming to the fore tend to have smaller market capitalisations than their average peers and higher free cash flows. He suspects the M&A boom will continue into the middle of the rate hike cycle.
The second is a series of pair trades, with O’Sullivan arguing that low levels of volatility are ‘permissive’ in terms of allowing investors to make bets between companies. For such pair trades, he targets similar businesses in a sector to identify those where relative value can be found.
These are based on differences in recent price performance, analyst recommendations, and Credit Suisse’s Holt valuation system.
Pair trading has generated 5.5% for him in the year to date.
‘It will work its magic while I am on the beach and markets are quite calm,’ he said.