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Managing market volatility

 
Iain Barnes
Global Markets Continue Last Week's Steep Decline
Low interest rates have contributed to recent low volatility. (Source: Shuttershock)

Volatility is an important measure in financial markets. At times of stress or uncertainty, volatility rises.

In contrast, low volatility is usually associated with stable or predictable conditions. In recent months, volatility has been relatively low. A good indicator of this is the VIX index. Although this measures volatility implied by derivatives on US stock markets, it is seen as a good guide to volatility in global financial markets. In May the Vix averaged 10.9. By way of comparison, this reached 22.5 at the time of November's US election and during the financial crisis it registered an intra-month high of 80.9 in November 2008.


(Source: Bloomberg, Chicago Board Options Exchange, Netwealth Investments calculations)

What do we mean by market volatility?

Another way of seeing this low volatility of markets is by looking at the daily changes in stock markets. So far in 2017, the FTSE All Share has only registered a daily move larger than 1 per cent (either up or down) on four occasions. This compares to an average of 68 such days in each year since the turn of the century. Again, in 2008, which captured the worst of the global financial crisis, this figure jumped to 168. So by any standards, this has been a year of very low volatility.


(Source: Bloomberg, Netwealth Investments calculations)

Current market conditions

There are a number of reasons why volatility has been low recently. One, is the relative predictability of economic policy - and in particular of monetary policy. Central banks, including the Bank of England and the US Federal Reserve, have gone out of their way to manage financial market expectations and avoid taking unexpected measures. Given the critical role that monetary policy has played in recent years, the predictability of policy is an important influence.

Markets are always acting as a gauge of various risks, but it’s important to remember that their attention could be grabbed by something quite unexpected"

Also, it is not just expectations but the monetary policy itself that has contributed to low financial market volatility. Low interest rates and quantitative easing have provided an important stabilising economic influence on the UK and other Western economies and, in turn, markets have reacted to this by extending expectations of both easy borrowing conditions and higher corporate profits. All in all, it has offered up quite a sanguine environment for investors.

However, as welcome as this is, it can create challenges and savers and investors need to be aware of these. An increase in uncertainty or heightened risk could push volatility higher. If this coincides with worries about the economic or policy outlook, then markets could suffer if they have not been pricing sufficiently for uncertainty. Markets are always acting as a gauge of various risks, but it’s important to remember that their attention could be grabbed by something quite unexpected, as well as the topical concerns that are covered in headlines currently.

One risk is that investors extrapolate the current environment too far into the future, and with too much confidence. Recently there has been a small increase in volatility due to political uncertainty in both the USA and Brazil, where investors are more accustomed to turbulence. There is every chance that with valuations stretched in some markets, the current consensus of continued calm could be disrupted.

Netwealth’s approach

At Netwealth, we construct our strategic allocations with the primary motivation of providing globally-diversified portfolios that are designed to ride through periods of higher volatility and deliver client objectives over the long term. More turbulent conditions will undoubtedly prevail at some stage in the future and whilst we’ll continue to monitor markets for any cyclical risks that might knock performance off-track, maintaining discipline in the investment approach will be key to delivering long-term returns. Many investors will tend to panic at the sign of more choppy markets, hoping they can call the peaks and troughs. We think it is key to remain true to your risk profile and resist any knee-jerk reactions that may do more damage than good.

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