Volatility in the markets may be higher not just in the near-term cyclical environment but on a long-term secular basis, as well. Over the past 30 years, long-term growth drivers that are now absent helped to lengthen and moderate the business cycle, including steady declines in interest rates, tax rates, and inflation. A potent driver of economic volatility in the years ahead may be the swings in fiscal and monetary policy. Investors must be well prepared to manage volatility and use it to their advantage in the years to come, since waiting it out is not an option. We believe thriving in volatile markets requires incorporating volatility themes into your portfolio, including a focus on yield, utilizing volatility-thriving investments, and a tactical rebalancing approach.
Thriving in Volatile TimesElevated volatility has been an enduring characteristic of the markets in recent years. Friday's sharp pullback of about -2.9% in the S&P 500 after a 7% run up in the prior nine days was a reminder that volatility remains high even on a daily basis. This is due, in part, to the current stage of the economic cycle notorious for highly volatile markets. But there are longer-term forces at work likely to keep volatility above average, as well. The economic recovery in the United States that likely began a year ago is ending. The United States economy is now expanding to new highs, not just recovering.
- Nominal GDP, the broadest measure of economic activity, has already recovered all the ground it lost during 2007-09 and is now back above its prior peak.
- Consumer spending has also rebounded to new all-time highs.
- During the second quarter earnings season now underway, a number of companies have reported sales or profits that are at new all-time highs, including chip maker Intel (INTC).
- Leading indicators of economic activity have begun to roll over as the strong growth momentum that is characteristic of a recovery starts to fade.
Historically, what ultimately follows the economic recovery has typically been a successful transition to a multi-year period of economic growth. However, about a year after the recovery begins an uneven pattern in the economic data and market performance emerges that we call a "soft spot." The soft spot tends to last for several quarters as the monetary and fiscal policy drivers of the rebound fade and private sector driven growth slowly picks up. In prior commentaries, we showed how each of the past ten recessions encountered a soft spot about one year after it began that led to increased market volatility. During the current stage of the economic cycle, heightened economic volatility leading to above-average market volatility is common. However, volatility in the markets may be higher not just in the near-term cyclical environment but on a long-term secular basis, as well. Investors must be well prepared to manage volatility and use it to their advantage in the years to come, since waiting it out is not an option.
Greater Economic VolatilityIn recent decades, economic cycles (the period from one recession to the next) have smoothed out and lengthened to average about 7-10 years, changing drivers may lead to shorter and more volatile economic cycles in the future. In the 1980s, 1990s, and 2000s, powerful, long-term secular growth drivers helped to lengthen the economic cycle. These included steady declines in interest rates, tax rates, and inflation while the overall level of debt (leverage) was steadily rising. The absence of these factors going forward may heighten economic volatility. An even more potent driver of economic volatility in the years ahead may be the swings in fiscal and monetary policy.
Volatility for the Long TermWhat the changing drivers of the economy mean for investors is not the end of growth (although growth may be slower over the long-term), but of an environment of heightened economic and market volatility. The argument we present may seem theoretical and heavily dependent upon historical data. However, we our view is currently supported by reliable forward-looking indicators. The Federal Funds rate less the pace of consumer spending provides a gauge of how much stimulus is being provided by the Fed less the pace of growth already taking place. As you can see in chart 4, when we advance the Fed funds less consumer spending measure by two years, to account for the lag time in Fed policy, it forecasts very accurately where the VIX, or S&P 500 volatility index, is headed. The VIX reflects market volatility. In essence, the higher the level of the VIX the greater the implied volatility for the stock market. Since, markets have become more closely linked volatility for one market likely means volatility for all.
How to Thrive in Volatile TimesWe believe thriving in volatile markets requires incorporating volatility themes into your portfolio, including: a focus on yield, utilizing volatility-thriving investments, and a tactical rebalancing approach.
- A higher yield may benefit portfolios by providing a consistent income component that is received regardless of volatile price movements. There are several ways to help benefit from a focus on yield, including High-Yield Bonds, Real Estate Investment Trusts (REITs), Emerging Market Bonds, and Dividend Paying Stocks.
- Higher correlations among asset classes and shorter economic cycles mean alternative investments strategies play a bigger role in portfolio construction. Alternative styles such as global macro strategies benefit from heightened volatility helping to not only potentially improve returns, but also help reduce portfolio risk.
- A volatile market that produces multiple rallies and pullbacks, but remains largely range-bound, creates many opportunities to enhance performance through tactically re-balancing portfolios by taking profits when markets are at the top of the range and seeking attractive opportunities at the low end of the range.