Market Volatility

Not all market volatility is created equal

To make sense of today’s volatility, it can be helpful to look at the past. It demonstrates that market volatility isn’t one-directional or constant in magnitude, nor is it always spurred by the same type of risk.
Historical context can be a powerful tool for understanding volatility.

Rising market volatility generally reflects one of three types of risk:

Episodic: Characterised by short-lived, albeit legitimate, risk events that prove to be less enduring—often with the benefit of hindsight. A good example comes from early 2018, when concern about rising interest rates and an unwinding of levered short-volatility positions led to a short-lived spike in volatility. August 2024 provides another, more recent, example, when a soft jobs report and a crowded carry trade unwinding worked together to create a volatility spike that dissipated within a week.

Economic cycle-driven: A rise in volatility often linked to economic slowdown and the fear—and sometimes the realisation—of recession. Notable instances include the bear markets of 1980–1982 (when the Paul Volcker-led Federal Reserve was taming inflation), the 2001 recession that accompanied the dot-com bubble burst, and the 2022 bear market, which was driven by a spike in post pandemic inflation and the Fed’s interest-rate-hiking cycle.

Existential: The prospect of a systemic collapse of the economy and/or the financial system that can drive periods of unprecedented uncertainty and extreme market downturns. This is a “once in a generation” type of risk. Recent examples include the global financial crisis of 2008–2009 and the initial phase of the COVID-19 pandemic in 2020. “Economic freefall”—a phrase commonly used by commentators to describe such events—captures the sentiment well.

Volatility is likely to remain in play given a range of factors

The current market volatility is not driven by existential or episodic risk concerns, but by economic cycle-driven concerns. Accordingly, it is likely to prove somewhat durable—think weeks and potentially months, not days—for three broad reasons.

First, the depth and breadth of policy uncertainty is a global dynamic, and the uncertainty remains at historically elevated levels in some countries, contributing to market volatility. Some initiatives also carry the potential to weigh on economic growth while adding pressure for higher prices.

Second, apart from policy uncertainty, deeper currents driving the U.S. economy are likely to be more disruptive than before. As Vanguard’s global chief economist underscores, the U.S. economy is going through the initial phase of what we consider to be the contest between two megatrends to define the decade ahead—an artificial-intelligence-driven productivity boost and the weight of a secular rise in structural fiscal deficits on the economy.

As AI spreads through the U.S. economy, the implications for the labour markets and competitive dynamics for many industries will be anything but trivial. With the potential tectonic shifts underpinning the transition, the tug-of-war may manifest in disruptions that challenge the status quo and contribute to heightened market volatility. At the same time, the bond market is likely to continue to pay close attention to the evolving debt dynamics and may not hesitate to price in requisite premium should it deem that warranted.

Third, the Fed approaches this confluence of forces with inflation not having returned to its 2% target. If inflation rises anew, policymakers, concerned not only with full employment but also with price stability, may feel constrained in their ability to support the economy through interest rate cuts.

What to do when times are volatile?

ONE: DO NOT PANIC!

When you are seeing daily market volatility, it’s easy to lose perspective. Don’t get scared or make an emotional decision based off what you are seeing in the headlines.
It’s important to keep your long-term goals in perspective.

While it can be tempting to ‘time’ the market volatility, it’s very difficult to predict from day to day which way the markets will run. Often, the best and worst days can be clustered – some of the best days in the market occur in what ultimately turns out to be a down year and some of the worst days can occur in positive years.

And being out of the market means that you could miss out on some of those best days, which can jeopardise long term returns.

A true hallmark of a balanced portfolio is the ability to withstand the inevitable (and unpredictable) periods of significant drawdowns and remain invested in equities in pursuit of eventual capital appreciation, even during times of market volatility.

The equity risk premium—the higher returns investors expect stocks to deliver—comes with the potential for a volatile ride. It’s important not to let one’s risk tolerance and time horizon get out of sync with the portfolio.

TWO: CHECK YOUR FIXED INCOME ALLOCATION

After years of stock market outperformance primarily driven by growth tech firms in the U.S., some investors may be overallocated to U.S. equities. At least some of them may benefit from recalibrating their stock-bond mixes so that their fixed income allocations can act as effective ballast when equity prices tumble.

Many advisers and investors are still scarred by the volatility of 2021 and 2022. But we are in a different environment now, where fixed interest portfolios are much less sensitive to bond market volatility. An oft quoted rule of thumb is that fixed interest portfolios can be expected to experience a decline in price commensurate with their duration (e.g. for every 1% shock to the bond market, a portfolio with a duration of 3 years, can expect to experience a 3% decline).

However, the starting point is important – a portfolio with a 3-year duration (for example Australian Credit) yielding 4% which then experiences a 1% shock can expect a return in the order of 4% – (3 x 1%) = ~ 1%.

Further, moving from a “hike hold” era (the end of interest rate hikes but rate cuts not yet started) to “ease” has historically been a period when investors have benefitted from having bonds as a portfolio diversifier.

And while cash may be a tempting refuge, over the long term it has been less effective in building wealth and acting as a portfolio ballast.

Also, don’t forget to check that your fixed income is actually defensive, is priced transparently and most importantly will be liquid and available if you need it. In times of market volatility, this becomes even more critical. Private Credit has become a popular inclusion in portfolios in the past few years due to the higher yields on offer, but the trade-off (in the fine print of many PDSs or offer documents) is the potential for access to funds to be cut off at the manager’s discretion.

THREE: CHECK YOUR GROWTH BIAS

Others may benefit from adjustments within their equity sleeve, restoring the balance between U.S. and ex-U.S. and/or growth and value stocks, especially in times of market volatility.

During 2024, satellites in the Morningstar category ‘Equity World Large Growth’ featured in the top three most popular category of funds. This skew to growth is most likely explained by the strong rally of growth relative to value in recent years.

FOUR: CONTROL WHAT YOU CAN CONTROL

At the end of the day, though, the way the market responds to the daily news cycle is not really within an individual investor’s control. Principles for Investing Success emphasise a central theme: Direct your attention towards aspects that are within your control. While market volatility is inevitable, there are only a few key factors that can be readily controlled by investors: costs, asset allocation and investment contribution rates are some of the biggest. These can be driving factors in the final investment outcome of a portfolio.

The below base case assumes a 25-year-old investor investing to retirement age 65, earning $80,000 per annum growing at a real rate of 2%. The base case assumes 10% savings rate, 100bps fees and 70% growth/30% defensive portfolio. Percentage values shown indicate the different in median final values of the adjusted portfolios relative to the base case.

· A 50bps reduction in fees could improve the base case by around 11%.
· Moving to a more aggressive risk profile (90% growth) could improve the base case by around 16%.
· Increasing the savings rate from 10% to 15% could improve the base case by around 50%.

And during this volatile period its worth reflecting on some quotes from someone who bore witness to many market ups and downs, Vanguard founder, Jack Bogle.

“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.”
“While rational expectations can tell us what will happen, they can never tell us when.”
“While the interests of the business are served by the aphorism ‘Don’t just stand there. Do something!’ the interests of investors are served by an approach that is its diametrical opposite: ‘Don’t do something. Just stand there!”
“As motion increases, returns decrease”

Lastly, “Stay the Course!”
Thanks for reading!