The Volatility Regime Re-Visited

  • We expect the consolidation in Europe’s equity markets to extend into December. Neither sustained advance nor substantial correction: is this the perfect consolidation?
  • The change in the volatility regime in the trans-Atlantic space has been validated this year. Volatility in all major financial markets should begin to revive next year, but modestly, if only because Central Banks will work to anchor expectations for short-term rates. We should begin to see the emergence next year of a positive correlation between the value of the US$ and most measures of volatility.
  • We reconsider the global consumer space. The re-rating of emerging consumer stocks has finally climaxed. Within trans-Atlantic markets the relative valuation of the Staples category has peaked, even as that of Consumer Discretionary has continued to rise.

Recommended sector and market asset allocation

It is appropriate that this exceptional year in Europe’s equity markets is ending in fatigue rather than in anxiety. The change in the volatility regime has been validated this year. The binary asset correlations produced by the practice of extreme monetary policy have broken down, leading to the collapse of the positive correlation between the pricing of equities and of secure debt that is one of the outstanding features of 2013. The argument was that equity volatility would remain subdued. So it has been. As a consequence, equity returns have been more evenly distributed through time than in previous years. We anticipate that volatility in all major financial markets should begin to revive next year from the super-low levels established this year. However, the revival should be modest, if only because Central Banks will work to anchor expectations for short-term rates in the developed economies. 2015 promises to be the year in which financial volatility breaks out to higher ground. The behaviour of the US$ should correspond with the idea that financial volatility, led by bond markets, is describing a bottoming pattern through 2013-2014. We should begin to see the emergence next year of a positive correlation between the value of the US$ and most measures of financial volatility.

In Europe the appetite among investors for higher risk stocks has gone. The second wave of recovery of the region’s “domestic value” assets peaked in late-October. It is not coincidental that the impulse from better than expected data for economic activity has faded. Defensive stocks have stabilised. Smaller caps have ceased to out-perform. The markets of the EZ are no longer out-performing. We expect the Thanksgiving holiday to trigger another small setback on Wall Street. What prevents market correction is the fear that Wall Street may continue to rise, which is another symptom of the change in the volatility regime. The Japanese market should be the outstanding out-performer of this quarter due to the renewed depreciation of the Yen. In this context the consolidation in European equity can extend through December: neither sustained advance nor substantial correction. Is this the perfect market consolidation?

We reconsider the global consumer space. There are two new developments here this year that we consider to be significant. First, the re-rating of emerging consumer stocks relative to their counterparts in developed markets has finally climaxed, at the highest relative valuation on recent record. Second, within trans-Atlantic markets we have received confirmation that the relative valuation of the Consumer Staples category has peaked, even as that of Consumer Discretionary has continued to rise.

Weightings and asset allocation for the MSCI Europe Universe



22/11/2013 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocation (%)
Consumer Discretionary 9.9 1.1 OW 14
Automobiles & Components 3.0 1.6 OW 4
Consumer Durables & Apparel 2.7 1.2 OW 3
Consumer Services 0.9 0.9 OW 1
Media 1.9 0.8 OW 3
Retailing 1.3 0.9 OW 2
Consumer Staples 14.1 0.5 UW 11
Food & Staples Retailing 1.7 0.8 N 2
Fod Beverage & Tobacco 10.7 0.5 UW 7
Household & Personal Product 1.8 0.5 UW 2
Energy 9.4 1.0 N 9
Financials 21.6 1.5 OW 22
Banks 11.0 1.5 N 11
Diversified Financials 4.0 1.6 OW 5
Insurance 5.6 1.4 OW 7
Real Estate 1.0 1.1 UW 0
healthcare 12.7 0.5 N 12
Healthcare Equipment & Services 1.2 0.4 N 1
Pharmaceuticals & Biotechnology 11.5 0.5 N 11
Industrials 11.6 1.1 OW 12
Capital Goods 9.0 1.2 OW 10
Commercial Services & Suppy 1.4 0.8 N 1
Transportation 1.2 1.0 N 1
Information Technology 3.1 1.0 OW 4
Software & Services 1.4 0.9 OW 2
Technology & Hardware Equipment 0.9 1.2 OW 1
Semiconducors 0.9 1.0 OW 1
Materials 8.1 1.3 N 8
Telecommunication services 5.5 0.8 OW 6
Utilities 3.9 0.9 UW 2
Exposure to risk
(beta value)
  1.04    
Lquidity ratio   5%    
* The exposure to risk is measured by the weighted average of 2-y betas.
We manage the liquidity ratio within a 0-10% rank.
Source: Kepler Cheuvreux