Volatility: the new normal
Markets were surprisingly calm in 2017 but now “The Times They Are A Changin’!”, in the words of the great American singer-songwriter, Bob Dylan. Last year, in fact, went down as the first one on record in which the S&P 500 stock index posted a positive return in every single month. This year, however, fears of an escalating trade war, rising short-term interest rates and a recent whiff of inflation caused risk markets to retreat sharply in February and March after a strong showing in January.
Over Q1, most stock indices finished flat to slightly down, but this result belies an historically high level of volatility. The CBOE VIX index, a standard measure of market vicissitudes, spiked dramatically in 2018. From an average reading of just 11.09 in 2017, the VIX has so far averaged 17.35 in 2018, an increase of over 50 per cent.
Looking at other indicators, the S&P 500 has shown the highest sustained volatility we have seen this decade. For example, the majority of the days in February and March experienced price moves of greater than 1 per cent and on March 28 the Nasdaq market registered ten different 1 per cent moves in just one trading day!
What has led to these big price swings? Well, on the one hand investors are encouraged by a likely double-digit percentage increase in corporate profits this year boosted by US tax reform, expected to significantly boost bottom-line earnings. But on the other hand, higher interest rates, uncertainty over trade tariffs and the ongoing political dysfunction in Washington often strike at the heart of investor concern.
The concept of a “new normal” was created just after the financial crisis began to subside in 2010 but needs revisiting. Investment company Pimco actually coined the term with a paper entitled Navigating the new normal in industrial companies. The years between then and now were more or less accurately forecasted to be a long slug of anaemic global growth, lower interest rates, low inflation and subdued volatility.
Eight years later, however, central banks have begun to sing a different tune. Slowly but surely, the moribund global economy appears to be showing signs of life. Both the International Monetary Fund and the Organisation of Economic Co-operation and Development have recently lifted their forecasts of global growth for 2018 and beyond.
Better growth necessarily begets the process of unwinding monetary stimulus, which in turn increases market volatility as have been seen in recent months. The unnatural force of indiscriminate central bank buying in the markets is slowly disappearing and that leaves traditional investors to pick up the slack. Unlike the central banks, investors are not mandated to buy anything. Private-sector investors typically pay close attention to economic forces such as inflation, geopolitics and credit quality. In general, traditional investors are more fickle and that leads to greater volatility.
The US is leading the charge towards the new paradigm as it often does. Interestingly, America’s Fed is withdrawing monetary stimulus by winding down quantitative easing, while simultaneously raising interest rates. This means America is being more aggressive than say, the European Central Bank which began tapering its QE programme but is probably very far from raising interest rates in the near term.
The ECB agreed last October to reduce its monthly bond buying from €60 billion per month to €30 billion this year through at least September. Going back to 2008, we first had the co-ordinated central bank interest rate cuts, then we had broad-based QE. Going forward, regions such as Europe and perhaps even Japan will likely to use a “first in, first out” programme of winding down QE before hiking interest rates.
In addition to the global shift in monetary policy, fiscal policy, particularly that coming from the US remains increasingly uncertain. One study showed that the benefit of President Trump’s tax cuts could be completely wiped out by an all-out trade war. Moreover, the consistently erratic behaviour of America’s “Tweeter-in-Chief” is likely to continue to keep markets on edge. Over the past decade, political dysfunction in Washington has become part of the “new normal” but the current administration appears to be taking it to a new level.
Looking ahead, we foresee ongoing market volatility as investors weigh the opposing forces of an improving economy — although possibly impaired by a trade war — against the withdrawal of central bank support. In this environment, we look for sell-offs in individual securities as opportunities to add to our higher quality positions for the longer term.
The strategy of buying dips should work for accumulators, but those in the drawdown phase of their investment programme face greater challenges. For those needing cash from their investment portfolios, keeping a sharp eye on markets will be critical to managing the risk of having to sell good securities into a sudden market downturn, thereby reducing capital needed in later years. Investors looking to navigate this increasingly volatile environment would be wise to have professional advice.
• Bryan Earle Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information
• This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority