By Morgane Delledonne, ETF Investment Strategist at BMO Global Asset Management.

Morgane Delledonne, ETF Investment Strategist at BMO Global Asset Management

Exiting the expansionary phase

Developed markets ETFs have recorded the largest global net outflows month-to-date, while relatively cheaper emerging market assets gathered net inflows (see Figure below). Market corrections are likely to become more frequent in the late-cycle phase, and volatility could erode long-term returns.

The October global market rout looked like a market correction, similar to the one in February, rather than a shift in the economic outlook. After examining current market indicators compared to their levels prior to the past two major financial crises, we are cautiously optimistic about the global stock market.

Source: BMO Global Asset Management.

Current equity valuations are stretched and in line with levels seen prior to the 2007 crisis but corporate profitability is high overall. Globally, companies exhibit a lower equity multiplier than before the past two crises, as well as lower financial leverage. Economic activity is strong, evidenced by high US manufacturing PMIs, albeit losing momentum.

Market indicators also point to relatively sound conditions but raise some warning signals. The US Treasury yield curve is almost flat, which has been a downturn signal in the past, and the US yield gap, defined as the difference between the average dividend yield of the S&P 500 Index and the 2-year US Treasury yield, is negative and declining.

As we move towards a mature global economy with increased economic and geopolitical uncertainties, the low volatility regime is likely to end. The upcoming US mid-term elections, the ongoing Brexit negotiations, the Italian fiscal challenges, the increase in US interest rates and the threats of global trade wars, are all likely to continue to act as disruptive factors for global markets. Overall, market volatility is expected to remain elevated as the economy moves away from the expansionary stage to enter a late-cycle phase.

Volatility can erode long-term returns

The February and October sell-offs have led many investors to look to reduce volatility and downside risk in their portfolios. One way of achieving this is through income-producing investments. The stream of income acts as a downside buffer and enhances yields, lowering the volatility of returns. This is a distinct advantage in uncertain times. In ETFs for example, volatility can be reduced through using a covered call overlay. This involves selling call options against an equity index in exchange for an immediate additional cash flow (the call option premium) on top of the stock dividend, increasing the overall yield of the portfolio.

October implied volatility overview

The chart below com­pares the implied volatil­i­ties of S&P 500 call options at different strike prices before and after the October sell-off. The increase in over­all implied volatil­i­ty following the market correction (upward shift of the implied volatility curve), suggests that market participants expect volatility on the S&P 500 index to remain elevated in the month ahead. There is more demand for put options implying that market sentiment is becoming more negative on the upside potential for the S&P 500 index. Overall, option pricing suggests that the US market has possibly already peaked.

Source: BMO Global Asset Management.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)