The outlook for macro-economic and financial markets volatility is important for any asset allocation decision. A time period of low volatility (such as in the run-up to the financial crisis) sees investors moving into any sort of carry trades, depressing risk premia in turn. A period of high volatility such as ever since the onset of the crisis in 2007, destroys the rationale for carry trades, renders existing positions less desirable (just because of the higher volatility) and acts to increase any king of risk premia (be it the equity risk premia, risk premia for corporate bonds as well as the term premia incorporated into longer dated government bonds).
So where are we headed over the next few years in terms of volatility?
What we do know about macro-economic and financial markets volatility is that:
a) the so-called 'Great Moderation' has depressed the volatility of growth, inflation etc. in a statistically significant manner. However, macro-economic volatility spiked during the financial crisis
b) academic research gives several reasons for the 'Great Moderation', some of which should survive the financial crisis (increasing importance of industries which exhibit only limited cyclicality such as healthcare and education/reduced importance of cyclical industries such as manufacturing; better inventory management with lower inventory on average due to just-in-time production; empirically higher stability of inflation at low levels of inflation) and some of which have probably been only temporary (new financial instruments lead to a more efficient allocation of risk, especially credit risk) while for others it is too early to tell (improved macro-economic policy).
c) financial markets volatility is reduced during periods of increasing leverage in the financial sector and raised during periods of deleveraging. Financial markets volatility is also higher during recessions than during boom periods.
I think a lot of countries will exhibit relatively limited macro-economic volatility in the years ahead with the huge volatility of the past two years proving to be temporary. For one, as written frequently, my outlook remains that inflation will be low for an extended period of time in most of the so-called 'developed' economies. This per se should call for a relatively limited macro-economic volatility. Clearly not as low as in the run-up to 2007 but significantly below what we saw over the last quarters. Furthermore, I think that most of the financial sector deleveraging is behind us which should as well help to reduce volatility.
The key risk is that inflation shoots higher (again we will see that in some countries amid a currency crisis/sovereign default but not in the US or the Eurozone) which will bring with it a sharp rise in macro-economic volatility.
From this perspective, the carry trade is not dead over the medium term. (Higher-rated) corporate credit should profit and combined with a low growth outlook it suggests that developed economies' credit markets should hold a more attractive risk-return profile than equity markets.