Stock market returns soared in 2017, with the MSCI World index adding on 22.4% over the period and the S&P 500 index increasing by around 17%.
The growth momentum carried on into early 2018 as the US market rose another 5% in January—and then the February rollercoaster began, with both the S&P 500 and the Dow Jones Industrial indices shedding over 1,000 points in a few days, wiping out the previous two months' strong gains and a little more. Since then the market appears to have found a floor, at least for now, but remains somewhat jumpier than before.
The closely watched CBOE Volatility Index, which is better known as the VIX and measures volatility expectations based on what is implied by the cost of S&P 500 index options, is still well in the 20s, having bumped along the 10-12 mark for most of 2017.
Market watchers have chalked up this increase in volatility to a number of reasons: concerns about rising US interest rates (the Federal Reserve hiked rates marginally three times in 2017 and is projected to do something similar in 2018); excessively high company share valuations; inflation fears as US wages belatedly begin to improve (potentially prompting more aggressive rate tightening); computer-driven trading algorithms; and the idea that volatility levels had been kept artificially low for years by the trillions of central bank dollars flooding markets as a result of quantitative easing (which the Fed has now begun to reverse and the European Central Bank is slowing).
We asked four experts if this run of volatility will continue going forward, and what investors should do to protect themselves.
Olivier d'Assier, head of applied research for Asia Pacific
Volatility is back and is here to stay this year. The key drivers are interest rate volatility (which acts as a catalyst for volatility in all other asset classes such as currencies) and geopolitical risks.
The fundamentals have changed, and investors should stop thinking otherwise. Interest rate volatility is once again the cross-asset class volatility driver it should be, and the ongoing dislocation among the [Fed, ECB, Bank of England, and Bank of Japan] will only exacerbate that.
The rise in government bond yields is (after a decade-long absence) is challenging yields in risky assets—e.g. stocks, [corporate bonds]—at a time where the latter’s volatility is increasing. Investors will need a lot more conviction of higher capital gains to support their decision to stay in risky assets.
In the short-term, the losses of the past two weeks were much bigger than the low-volatility regime of 2017 forecasted at a time when market volumes spiked. These recent unexpected losses will increase the ranks of risk-averse investors.
Wait for the other shoe to drop in the coming months before thinking about going back in (think September to October 2008, then February 2009!). The losses this time will not be so severe, but coming from a low volatility base they hurt just as much, and thus hedging, not a necessity during 2017, will also be key this year.
Going forward, investors should switch from forecasting individual stocks to factor returns. If investors deem that they need to be in the market right now, underweight those factors that have outperformed in 2017 (growth, momentum, leverage), and overweight those that underperformed, or those that can perform well in a rising interest rate environment.
Stephen Pau, chief investment officer
Hefeng Family Office
We have seen low volatility in the last couple of years, possibly due to a low interest rate environment, slow earnings growth from companies across the globe, and the progressive economic recovery. However, we are now approaching the end of an economic cycle where the interest rate is starting to rise (conservative moves towards more moderate rate rise), higher [price/earning ratios] found in companies, and a rising [US] Treasury bond yield. Therefore, we believe volatility will probably increase going forward compared to the low level that we have seen over the past few years.
Imagine the situation where we are driving a car with a higher speed than in the past. This would be more difficult to manage and we would need to hold on to the steering wheel more tightly. Therefore, with a relatively higher P/E in some developed markets, any slight change in economic data can easily cause a spike in volatility and alters investors' risk and return profiles quite significantly, and therefore we should be ready for higher volatility and to embrace it as there are more uncertainties—e.g. [more] moderate or aggressive rate hikes—in the current environment.
Maybe now is the time to consider adding a bit of hedging instruments to the portfolio to protect against potentially higher volatility and to control downside risk. However, the size of the hedging instrument will vary according to portfolio requirements and our perception regarding the economic cycle.
Hervé Lievore, senior macro and investment strategist
HSBC Global Asset Management
Compared to the multi-year lows reached last year in terms of implied and observed volatility, investors should expect higher volatility, on average, in 2018 in a context where inflationary pressures continue to increase and monetary policies are gradually normalised, particularly in the US.
However, economic fundamentals are likely to remain supportive in 2018, with earnings growth and ample liquidity driving risk assets. In times of heightened volatility and from a multi-asset perspective, we believe investors should keep a well-diversified portfolio and avoid overreacting to short-term market ups and downs.
Our assessment of risk premia still favours global equities, with a preference for European, Japanese and Asia ex-Japan stocks. Emerging market debt in local currencies, including Asia, also offer opportunities from a medium-term perspective.
For US Treasuries, the recent rise in yields has increased prospective returns, although we have not yet reached levels consistent with a more constructive view. We remain underweight in this asset class for the time being. However, 10-year [US] yields comfortably above 3% could shift our thinking. We believe this is possible in a bond-unfriendly environment, with upside risks to a faster-than-expected Fed tightening trajectory.
Vincent Chan, co-head of multi-asset
Fullerton Fund Management
The pre-conditions for this equity weakness were well recognised. 2017 was a year of low equity price volatility but such calm masked an impending fall—in fact, in instances where the US stock market fell by less than 5% intra-year, the average intra-year market decline in the following year was 12%.
After a strong performance in 2017, investors have continued to allocate more funds into equities, which pushed major equity markets higher by 7% to 10% in January 2018 and created an overbought situation. Concerns of over valuation were ignored as the fund flow was strong and positive.
What changed were a sharp fall in the US dollar and a concurrent rise in inflation expectations. As a result, the 10-year US government bond yield rose above 2.8%. What was significant was that the higher yields actually exacerbated equity market volatility.
As US interest rates push higher towards 3%, many strategists believe that we are nearing the threshold for a further fall in equities. We believe that economic fundamentals remain strong and the risk of a recession in the US this year is low. A synchronous global recovery, firm corporate earnings, and broadening [earnings] upgrades present a conducive backdrop for equity markets to remain resilient this year. Nonetheless, market volatility will continue to increase going forward.
In our view, overreactions by investors could instead be a buying opportunity as equity valuations will return to more reasonable levels (in terms of forward price-to-earnings). We advise caution and defensive strategies for now and wait for better opportunities to re-enter the market.