As market volatility declined through July to lows not seen in 10 years, investors should remember the old adages “nothing lasts forever” and “anything is possible.” The current low levels of volatility can create a dangerously false sense of security for investors, who are putting their portfolios at risk by not taking necessary precautions now.
Even Federal Reserve Chair Janet Yellen expressed concern, noting at a June 18, 2014 press conference, “Volatility, both actual and expected, in markets is at low levels… But to the extent that low levels of volatility may induce risk-taking behavior that, for example, entails excessive buildup in leverage or maturity extension, things that can pose risks to financial stability later on, that is a concern to me and to the [Federal Open Market] Committee.”
Advisors and their clients can take comfort in the prevailing view that the present low-volatility environment will not change immediately although it may experience shorter-term spikes as seen more recently in the third quarter. Most experts believe the current scenario will likely continue for at least another year, which gives advisors enough time to implement necessary protective measures for their clients, such as working with them to embrace a combination of investment strategies and objectives.
Low Volatility is Justified
Market volatility peaked during the financial crisis, but it has declined across multiple asset classes in the ensuing years. In fact, Goldman Sachs Global Investment Research found that option-implied volatility is at its lowest point in nearly a decade in many markets around the globe, including the U.S., India, Russia and China. Such low volatility across multiple asset classes, countries and currencies is very rare.
We see several factors that justify the current low volatility environment and view that it’s here to stay, at least for a while:
- The U.S. output gap between real and potential GDP is negative but heading in a positive direction, and the U.S. unemployment rate is high but declining— conditions which indicate the market is in the early part of the economic cycle, when currency and equity volatility are typically lower than normal.
- Lower volatility levels related to inflation and economic activity are usually tied to lower asset volatility.
- The market is currently experiencing a period of subdued financial stress due to the improving health of corporate balance sheets.
- Central banks have been aggressively trying to stimulate the economy by keeping short-term interest rates very low.
Warning Signs for Rising Volatility
History shows that low-volatility environments are not unusual or unprecedented, and can last for years at a time. For example, an extended low-volatility regime occurred during the 1950s and 1960s, when, according to Goldman Sachs, realized volatility was lower than this year’s low level of 10.9 percent.
History also shows that low-volatility regimes always come to an end. Advisors and investors should keep an eye out for several potential catalysts which could break this current cycle. The first to consider is that the Fed may need to increase interest rates sooner than expected if the U.S. economy accelerates and inflation becomes problematic. A sudden rate hike could shock the market and cause a rise in interest-rate risk, which may rapidly spread among various asset classes. For the time being, the Fed is not seeking to raise short-term interest rates; the minutes from the most recent Federal Open Market Committee meeting state that the central bank plans to keep short-term rates close to zero for a “considerable time.”
On the other hand, if the Fed is too slow to respond to market trends, then an asset bubble might develop, which could light the spark leading to a higher-volatility environment. A third potential catalyst involves geopolitical threats, such as the turmoil in Iraq, Syria and elsewhere in the Middle East and the conflict between Ukraine and Russia. These and other geopolitical uncertainties could escalate and cause a sustained increase in oil prices, sending volatility higher.
Stay Ahead of the Curve
When volatility rises, investors with portfolios using multiple investment strategies, asset classes and objectives will be the best-prepared to weather the storm. Now is the time for financial advisors to take the reins and help their clients understand how mixing strategies can help their portfolios navigate higher-volatility environments.
There are three basic investment objectives that most investors have in differing order of magnitude:
- Growth (Meeting savings goals and exceeding inflation rates)
- Income (Pursuing a sustainable stream of current income)
- Downside Protection (Shielding portfolios from a sudden downturn)
Today strategies are available for each investment objective. There is not a single strategy that can meet all three objectives. However by thoughtfully combining strategies in a manner that ties together the strategy’s purpose in a client portfolio with individual client preferences can create a more consistent experience for the client. Advisors can turn to financial services platforms offering investment and consulting solutions for assistance, since these organizations can provide educational materials to show what types of strategies and asset classes work well for particular investment objectives in certain circumstances, and also offer low-cost access to products that can complement clients’ portfolios.
The present low-volatility environment will eventually come to an end and as we’ve seen in the third quarter will experience some spikes along the way. However, the situation has a silver lining—it presents advisors with an opportunity to prove their value to their clients by taking preemptive steps to protect portfolios.
Zoë Brunson is Director of Investment Strategies at AssetMark, Inc., a strategic provider of investment and consulting solutions serving financial advisors.