The transition from liquidity-powered markets for risk assets to those influenced a lot more by fundamentals was never likely to be smooth, as it involved changes to drivers of investor behavior and market flows. Yet, despite this year’s unsettling spikes in high-frequency, two-way market moves, the right investment strategy is to “look through” the volatility.
Given the events in markets over the last few years, this approach has two main implications for long-term investors: On portfolio allocation, it calls for them to make either implicit or explicit calls on macroeconomic policies in the U.S., Europe and China; and, on specific exposures, it requires them to take a view on key emerging trends.
This year has been characterized by the kind of stock market movements that hadn't been seen for a while. As an example, Bloomberg Markets reported last week that there had already been three times as many moves of 1 percent or more in the S&P 500 this year than there were for the whole of 2017.
This increase in two-way price moves was preceded in 2017 by a highly unusual combination of market calm, strong performance and favorable asset-class correlations for conventional investment portfolios. Together, these conditions delivered one of the best years on record for traditional investors, both on a standalone basis and when risk-adjusted.
Against this background, investors shouldn't treat this year’s volatility as a strange phenomenon. Instead, they should think of it as payback for a period when a more normalized level of volatility was heavily repressed by significant non-commercial flows, including consistent buying of securities on the part of some large central banks and cash-rich corporates. This allowed markets to continuously sidestep fluid economic, geopolitical and political factors. As a result, market corrections became less frequent, less severe and a lot shorter in duration.
Low volatility is not the only thing that investors have de facto borrowed from the future. They have also borrowed growth, and not just through the rise in debt that has enabled a range of additional economic and corporate activities. The resulting impact on markets was turbocharged by investor conditioning to buy every dip and served to decouple more elevated market pricing from more sluggish fundamentals. That could be sustained as long as the non-commercial suppression of volatility remained strong, both in actuality and in investor perceptions.
This delicate balance is being redefined so far this year. But instead of experiencing a significant deterioration in fundamentals that pulls down elevated asset prices, markets are navigating a reduction in the potency of the volatility suppressors.
The central banking community, led by the Federal Reserve, continues to slowly transition away from the financial repression regime that has dominated its thinking and actions since the global financial crisis. Unlike during other bouts of volatility since the crisis, the end of quantitative easing purchases by the Fed, actual and anticipated balance-sheet reduction by the European Central Bank along with Fed rate hikes have not been accompanied so far this year by soothing words from central bankers to counter volatility spikes.
Investors should look through market volatility as long as it does not cause major technical dislocations and damage market functioning. They can draw comfort from the limited disruptions associated with this year’s collapse in short-vol trades and Bitcoin prices, as well as from the relatively limited widening in credit spreads.
All of which raises questions about the longer-term positioning of investment portfolios given the transition in market volatility.