Volatility re-emerged in 2018 with a vengeance, creating challenges for investors who have become complacent by last year’s placid conditions. In 2017, the markets enjoyed a Goldilocks environment by any measure, with realized volatility at 5.34%, the lowest on record going back to 1928, when the index was created.¹ Low volatility tends to correlate with strong returns, as seen in the S&P 500 returning a generous 19.4%.
In stark contrast, 2018 is proving to be markedly more volatile. While it is typical for a low-volatility year to be followed by one with higher volatility and lower returns, investors could benefit from understanding the top 5 reasons behind what’s driving higher volatility and what could further amplify choppy markets going forward.
- Some of this is cyclical. Keep in mind that our economic expansion turned nine years old in June, making it the second longest expansion since World War II. No one can know when, but the pendulum is destined to swing back.
- Blame or credit the Fed. The Federal Reserve initiated a cautious rate hike cycle in December 2015. Almost three years later, the Fed is gaining confidence and conviction emboldened by the economy racing at a pace above its potential growth. It now expects to raise rates four times in 2018, reflecting the low, and falling, unemployment rate and activity around renormalizing rates. When the Fed expresses intent to tighten monetary policy, markets rightly take notice and volatility often follows. It is troubling that a Fed rate hike cycle has proceeded each of the last three recessions.
- The prospect of trade wars looms. Protectionist trade policies have also caused significant market volatility, as uncertainty about escalation and retaliation of tariffs affects large multi-national companies, many of which have international revenue and supply chains.
- Passive investing prevails. This trend has concentrated investments in an increasingly smaller number of companies. While ETFs were in part created to offer a simple way to diversify, they have done the opposite. In 2017, 33% of S&P 500 gains for the year were driven by only 10 companies. But indiscriminate buying begets indiscriminate selling.
- The Fed is deleveraging its balance sheet. When this policy began in 2017, the Fed was transparent and minimized market disruption. While the Fed was slowly deleveraging, the ECB and the BoJ together added over $2 trillion to their balance sheets in 2017. In 2018, the major global central banks are expected to add less than $500 billion to their balance sheets, and 2019 could see even less. We simply have no historic precedent for major central banks deleveraging. If a massive inflow of liquidity arguably contributed to record low volatility, then the reduction or even removal of liquidity could well amplify volatility going forward.
Volatility is a challenge to advisors managing investment portfolios, but it can be downright terrifying for investors, particularly retirees. In a world where traditional assets are increasingly correlated, diversification will be critical to minimize the disruption to steady asset growth.