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A Return to Normal Volatility?
The equity markets have been extremely volatile over the past two weeks. The S&P 500 dropped over 200 points (almost 8%) in only a few days before bouncing back; January’s gains evaporated. Other equity indices showed similar results. Are these market movements perhaps the start of something big, or just the first step to volatility returning to a more typical level?
Why such a violent sell off?
Equity markets were up 22% in 2017 and an additional 7.5% though January 26th. This climb was unnaturally steady with little volatility during 15 consecutive months of positive returns. It can be unhealthy for markets to have such low volatility as this can lead to investor overconfidence, heightening the risk of sharper falls.
Many factors drove investor confidence, including strong economic data, and the prospect of US tax cuts driving corporate earnings higher. Nobody knows for sure, but some of the factors that likely contributed to the sudden turn down in investor sentiment and the markets were:
- Higher inflation expectations, and thus expectations that the Fed may hike interest rates by more than expected, potentially slowing the economy
- A sell-off in crypto currencies
- Program trading that reacted automatically and rapidly to higher volatility by selling equities to manage risk, leading to higher volatility
A fundamental issue, inflation, may have started a sell off but technical factors made it sharp and sudden.
What may this mean for the market?
The recent volatility does not signal that the equity bull market is over since economic fundamentals remain strong both in the US and abroad. That said there are good reasons to suggest that volatility should at least revert to “normal”. Asset prices have benefitted for many years from supportive monetary policy, strong corporate earnings growth, generally improving fundamentals (e.g. unemployment, capacity utilization, etc.), and generally falling bond yields. Monetary policy is tightening, bond yields are rising, and fundamentals are strong but flattening. Earnings while still strong may be peaking. Therefore, we are likely to move into a more challenging period for investments of all types as evidenced by greater uncertainty, and thus greater volatility.
What does this mean for retirement plan sponsors and investors?
- Reevaluate expected returns and risk. Consider rebalancing to lock in gains from asset classes that have had large returns.
- Higher interest rates mean lower annuity costs. Consider risk transfers or investing more in liability-matching assets.
- Defined contribution sponsors should review the level of risk in their plans. Would further market corrections impede the ability of older employees to retire? Is the level of risk in your Target Date funds appropriate?
- Institutional investors can consider limiting the damage they may sustain when equities meaningfully correct through explicit hedging strategies.
Volatility may have returned. Investors should prepare for what this means for their specific circumstances.