The Return of Volatility

16 July 2018

By Sheldon MacDonald, Co-Fund Manager HC Verbatim Multi-Index Funds

This year we have been saying that market volatility is set to return to normal levels. That mantra is still in place, especially in the light of recent political developments.

Italian drama uncovered

At the end of May we saw an increase in volatility. Following an inconclusive Italian general election in March, the two Eurosceptic parties trying to form a coalition were stymied by Sergio Mattarella, the current president. Mattarella blocked their preferred choice of Finance Minister, Paolo Savona, and subsequent attempts to form a ‘technocrat’ government also failed. This turmoil spooked the markets as investors feared any new vote could turn into a referendum to leave the euro.

The Italian micro drama led to a couple of days of heightened volatility. On Wednesday the market was pricing in the worst-case outcomes, but by Thursday things had settled down as investors realised that those worst-case outcomes were in fact fairly unlikely. Italian bonds rebounded strongly, and this was vindicated when a new coalition government was eventually agreed later in the week.

Return to the norm

The Italy drama was another in a series of episodes of volatility this year. In the past few years, with a synchronised global economic growth recovery in place, at least partly engineered by central banks’ easy liquidity conditions, volatility reached record low levels. As a result, investors had begun to become complacent about risks and were happy to keep buying. What we have seen this year is a return to fairly normal market reactions with investor sentiment swaying as news flow is received and digested. Previously, negative reactions to adverse news flow were muted by the overarching positive sentiment. Now we are seeing what we would normally expect when negative news breaks: a kneejerk initial reaction followed by the realisation that things aren’t so bad, bringing with it a rebound as investors return to the market. We saw this with the trade war scare, North Korea, and most recently Italy.  

Volatility can be self-fulfilling

This reintroduction of volatility into markets can be self-fulfilling. As volatility rises investors get more skittish, and can exacerbate the moves as they get nervous and sell when markets decline, and buy back when markets recover. Other investors may try to take advantage of volatility, believing that they can sell at the top and buy at the bottom. This is a difficult skill, and those that get it wrong can end up having to chase prices as they scramble to close their positions.

What’s next?

Volatility is usually triggered by a surprise, and by definition, surprises are difficult to forecast. The next catalyst could come out of anywhere. At the beginning of the year, few people were suggesting that a trade war would spark an equity sell-off. Likewise, North Korea wasn’t really on the radar as a source of risk - nor indeed as having the potential to be the positive catalyst it became when relations with the US briefly thawed!

But even though surprises are hard to predict, it’s important to remain vigilant, to consider potential sources of risk. Our process tries to identify the biggest areas of concern, and at the moment, we are monitoring the following:

  • China: the perennial risk of an economic hard landing
  • Liquidity: some fixed income markets could suffer if liquidity dries up
  • Trump: erratic policy decisions
  • Brexit: still a long way to go; all outcomes still technically possible
  • Sterling: currency strength could pose a threat for UK investors
  • US dollar: further dollar strength could be a risk to global growth
  • Oil: this has the capacity to affect inflation, either positively or negatively, with knock-on impacts on interest rates

What do we think?

At the moment we are reasonably sanguine on most of the potential risks highlighted above. Although some economic indicators have eased off slightly from very positive levels, the outlook for global growth remains strong. Our positioning is slightly ‘risk on’ as we focus on the long term and avoid overreacting to volatility. That’s not to say we ignore it, rather we try to avoid reacting to price moves that might be exaggerated and don’t reflect what has actually changed fundamentally.

 

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Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use.