The recent spike in market volatility has prompted references to the Great Financial Crisis - but maybe higher volatility is just the new normal.
Volatility is a statistical measure of the dispersion of returns, and it's a normal and inherent part of the investment process. It's easy to focus on the negative consequences of a rise in volatility, but higher volatility can also create investment opportunities if fear and a loss of confidence drive an over-reaction to short term events. Volatility is not constant, so investors should aim to be aware of when it's changing and whether these shifts are temporary or prove to be longer lasting. For instance, volatility can spike sharply for many reasons, such as the Asian financial crisis, 9/11, the European economic crisis, Trump's US election win and, more recently, US-China trade war fears. However, these spikes are not usually sustained unless they are accompanied by lasting economic or financial market impacts.
Over the past 12 months, there's been a notable increase in equity market volatility. This has raised questions around whether we're now entering a new and much higher volatility environment than the one that prevailed for the 6 years from 2012-18. To understand what this potentially means for investors, we need to look back at the causes of the most recent low volatility period and evaluate what's changing.
Why was volatility so low? There are several factors that supported the low volatility environment that persisted from the end of the global financial crisis through to late 2017. Perhaps most crucial was the persistence of central banks to reflate the global economy via both direct and indirect stimulatory measures. This included ultra-low interest rates, large doses of quantitative easing which created significant excess liquidity and more transparent forward guidance (to remove uncertainty around what policy intentions were). This was given extra impetus via the co-ordination approach of these policies across almost all major central banks and at times via stimulatory fiscal policy via government actions.
These ultra-accommodative policies reduced uncertainty by creating an asymmetric risk profile. Whenever a threat to the global economy emerged, global central banks would simply step up to offset this risk via cutting rates or adding more liquidity into the system. With so much excess liquidity made available, whenever risk assets were sold down, there was always a strong bid that underpinned the downside.
These actions had the desired effect of reducing volatility in financial markets which then allowed the price paid for assets to rise as well as providing a tailwind for decision making in the real economy where greater stability allowed better transparency on the outlook. Thus, while low volatility drove repeated screams of complacency, it was in fact a precursor to a prolonged period of one-way steady increases in risk assets.
However, all good things must come to an end, and as the US Federal Reserve began to raise interest rates, this signalled the end of the period of synchronized global monetary policy easing and the suppressant on voalitlity began to reverse course.
What does higher volatility mean for investors? A rise in volatility will not put us in unchartered waters. Investors have experienced periods of elevated volatility and come through it. Similarly, a spike in volatility does not necessarily mean investors need to adjust their asset allocation or portfolio provided they're consistent with long-term goals. Nevertheless, it does mean that investors might need to accept that the short-term value of their portfolio (and individual holdings) may deviate from expectations far more regularly then in a low volatility environment. However, in the long term, fundamentals should outweigh emotive factors in determining the returns from risk assets.
We think the key implications for investors from a rise in volatility can be outlined as follows:
First, prepare for lower returns. High volatility indicates greater uncertainty and investors usually require greater compensation - i.e. higher returns, for this uncertainty. Historically equity markets have performed better in low volatility environments than in high volatility environments. Annualised returns since the end of the GFC have been spectacular and low volatility has contributed to this. Investors must understand that this was not a normal period and that lower returns and greater price swings can be expected going forward.
Second, seek true diversification. Diversified portfolios are designed to provide good risk adjusted returns through market cycles. However, market crises like the GFC can see correlations across asset classes rise as all assets move lower together. High correlation is great when the returns are going up, but not so when the direction is down. Within a diversified portfolio, investors can lower their risk profile by owning more cash and government bonds.
Third, volatility reduces liquidity. Higher volatility means investors are uncertain and therefore less confident about what price to buy or sell at. If investors are forced to sell in this environment, selling less liquid investments can mean having to accept a price below fair value. Ensuring that your portfolio has adequate allocation to vanilla asset classes and investments like large capitalisation stocks and government bonds can help provide a liquidity buffer and reduce the risk of loss in a more volatile market.
However, at the end of the day, investors do not need to panic because volatility is rising. Stick to your investment principals, continue to react rationally and be prepared to look through "noise" in order to stick to long-term investment objectives. Don't be fooled into trying to time the market because as sure as day follows night, high volatility regimes are never forever.