Volatility really could be different this time
After lying dormant for nearly a decade, volatility has started to rumble again. But the nature of volatility has changed, creating dangers and opportunities for investors.
Market price swings have increased significantly since the start of the Covid-19 pandemic early last year. The volatility of global shares nearly tripled between 2019 and 2020; and the CBOE Volatility Index (Vix) remains at heightened levels compared to the last nine years.
This comes when the world’s central banks have fired off unprecedented amounts of policy ammunition; the pandemic has injected uncertainty into daily life; environmental, social and governance (ESG) principles are disrupting long-established business models; and many assets have record-high prices.
While some active managers may welcome greater volatility as a chance to display their tactical skills, most investors would rather it stayed low - especially the growing cohort of retirees.
But how different will volatility be in the coming 18 months? And what are the options for avoiding it?
A potent brew
There is no shortage of catalysts for increased market volatility.
As governments tentatively lift Covid-19 restrictions, the pace and degree of economic recovery – at national and global level – remains uncertain. Consumer confidence remains fragile, the employment outlook is mixed, and heavier taxation to pay for counter-pandemic measures looks likely.
Retail investors’ involvement in financial markets has also surged since last year. EPFR-tracked global and China equity funds have received strong retail inflows, and investors’ efforts to squeeze hedge fund shorts have garnered extensive publicity.
Meanwhile, investors of all stripes have been piling into emerging markets, a moody asset class with a history of unexpected challenges and volatility. EM companies have not been shy about taking on debt in recent years and some look overpriced.
Finally, inflation expectations have been rising since March 2020 and continue to grow thanks to governments' huge fiscal stimuli aiming to reflate economies. Research by EPFR shows bouts of higher inflation expectations correlate with faster rotation between asset classes, which is a hallmark of volatility. Higher inflation could fuel interest rate rises, which add risk for many companies’ share prices.
All these factors have boosted flows to funds that aim to profit from higher deviations in price movement. According to EPFR data, cumulative inflows to funds that invest in the Vix rose from around $9 billion last year to a new high of over $16 billion in early 2021.
New types of volatility
The Covid outbreak has changed the way many investors see volatility due to the unprecedented scale and breadth of the crisis. The pandemic highlighted the growing dangers of human interference with nature and decreasing biodiversity; the downsides of global travel and supply chains; and the lack of trust between politicians and the people.
The outbreak also exposed the inability of leaders to respond with coherent, synchronized policies. In the face of the pandemic, the world needed political certainty. But a study by Gachon University in South Korea found Covid-related economic policy uncertainty (EPU) influenced volatility even more widely and intensely than it did in the global financial crisis (GFC) of 2008-09. This led to rapid financial market contagion and share price swings.
Coming so soon after the GFC, the pandemic has fed into fears about the way globalization has enabled the effects of unwelcome social, economic, political and epidemiological events to spread and amplify quickly around the globe.
This will likely make investors more skittish and sensitive to a broader range of risk factors, from disease outbreaks to face mask sales and influenza indices in different countries. Investors will also be paying closer attention to a wide range of other potential indicators such as the dollar-renminbi exchange rate, gold price and Bitcoin price as possible bellwethers for another crisis and global contagion. Any spikes in these signals will cause more volatility than they did before.
Another difference this time around is the growing doubt about the ability of central banks to keep putting out economic fires. Investors are still watching US Federal Reserve meetings closely. But an EPFR analysis has shown that, since 2016, FOMC meetings have had a decreasing ability to move fixed income asset classes.
Havens, old and new
Traditional havens from volatility include cash, gold, inflation-indexed government bonds, and target return funds. Investors have also been rotating to funds whose mandates aim to minimize volatility.
At a stock level, quality, well-managed companies with large, predictable cash flows are defensive favorites.
Continuing to pile into stocks or sectors that got a short-term boost from the pandemic risks being caught in the bumpy process of mean reversion. But some sub-sectors, such as payment digitization, consumer e-commerce and green energy, should keep benefiting from structural shifts accelerated by Covid.
For those who want to keep investing in emerging market debt, local currency bonds have the potential to reduce volatility. Flows into local currency bonds have been rising since February, supporting prices, while EM hard-currency bonds have experienced hits. In wider debt markets, flows into long-duration bonds have been giving way to short-duration instruments, as they are typically less sensitive to interest rate rises and therefore less volatile when rates are changing.
But other new potential havens have emerged during the pandemic.
One is socially responsible investing (SRI) and ESG funds. Inflows to these have overtaken non-SRI/ESG funds since 2018; and been positive in almost every week since January 2020. If this demand continues, it will support their prices. Various studies also show that firms with higher ESG ratings have less volatile stock prices over the long term.
However, it depends on the makeup of your portfolio. If your ESG investments focus on newer, innovative industries with less-proven business models, they could still be vulnerable to price spikes. Diversification and investing in established business models should help mitigate this risk.
Or go off grid
Another potential haven is cryptocurrencies such as bitcoin. In contrast to mainstream ESG stocks, crypto prices have been highly volatile. But many more intrepid investors have still seen them as preferable to equities during the pandemic, with a dramatic rise in bitcoin inflows since last summer.
This has been supported by increasing global acceptance of the currency as an inflation hedge, and a particular surge in demand for bitcoin in China. Supply is short – with many investors holding on to their bitcoins – so prices have risen sharply over the last six months.
Cryptos are in an intensifying struggle with fiat currencies such as dollars to decentralize control over money. As the battle unfolds, they could become a useful performance measure for central banks with effective policies attracting money into fiat currencies, but ineffective ones sending markets fleeing into cryptos.
But most fiat currencies are much more stable than cryptos. Virtual currencies are still very new as an asset class and, as a store of value based on digital algorithms, poorly understood by many. As such, it is not clear when – or whether – their prices will stabilize.
Based on their wild price swings since 2017, cryptos could well prove to be even more volatile than the markets investors are fleeing. Furthermore, if these currencies become more mainstream and their prices do not stabilize, they have the potential to increase volatility across the whole financial system.