Stocks had been in an extraordinarily narrow trading range since mid-July. Realized volatility of the S&P 500 during this period dropped to levels not broadly seen since the mid-2000s.
That changed Friday, as equity indices posted sizable losses: The S&P 500 fell 2.4%, while the MSCI ACWI Ex-US index of global markets declined 2.2%.
Commentators generally blamed Friday’s sell-off on everything from investor disappointment over the European Central Bank’s decision not to expand its economic stimulus program (although this was widely anticipated) to poorer-than-expected economic data in the U.S. However, Friday’s activity was not the result of any one particular thing going “wrong.” The fact is, it is not unusual for a period of low volatility to be interrupted by a sudden and sharp move higher or lower. Friday, we got lower.
Bonds also suffered on Friday. The yield curves of global bond markets steepened during the second half of the week: While rates on 2-year notes were unchanged, rates on 30-year bonds rose by 12 basis points. Typically, a steepening yield curve is a positive sign for markets (generally a sign of improving economic conditions). However, many investors of late have been assuming that a steepening curve means global central banks’ accommodative monetary policies are likely coming to an end. Although we do not agree with that conclusion, the market’s interpretation on a day like last Friday should be taken into account.
GAIN: Active Asset Allocation
As Friday demonstrated, markets continue to grapple with the speed and timing of the Federal Reserve Board’s decisions regarding when to raise short-term interest rates (along with the possible actions/inactions of other global central banks). Investors’ collective conclusions are helping to drive a number of asset classes in today’s environment. The impact on interest rates is obvious, but investors’ expectations are also affecting the value of the U.S. dollar and, by extension, commodity prices and the attractiveness of foreign equities.
We believe that the Fed understands that the dollar’s recent strength is harmful to global financial conditions and, while not seeking to weaken the dollar, is mindful that material dollar strength could be excessively disruptive. If the Fed raises rates too fast, there would be upward pressure on the dollar relative to other currencies. Two “rising dollar” periods from the past 12 months—August 2015 and January/February 2016—have shown that a strong dollar policy is counterproductive to achieving the Fed’s growth and inflation targets, as both growth and inflation collapsed when the dollar rose.
As such, we believe that investors will continue to anticipate a slower pace of rate hikes in the coming weeks, which should lead to a stable-to-softer dollar—and should also benefit the markets.
Currently, the portfolios are emphasizing emerging markets, cyclical sectors like materials and technology, and small-cap stocks.
- Historical precedent shows that emerging markets positions can benefit from a softer dollar and stronger commodity prices. When the prospect of a strong dollar is less likely, investors tend to focus on the superior growth prospects emerging markets are capable of delivering.
- Cyclical sectors can take advantage of improvements in the risk-taking landscape brought on by less fear of a Fed rate hike, as well as by steady (or even increased) monetary easing by the European Central Bank, the Bank of Japan and other major central banks around the globe.
- Small-cap stocks have begun to regain favor with investors after more than a year of underperformance, as investors search for excess returns in rising markets.
PROTECT: Risk Assist
After an extended period of calm, volatility once again made itself known. The CBOE Volatility Index (VIX), which measures expected future levels of volatility, soared from 12.5 to 17.5 on Friday alone. It may be difficult to remember given the past few months, but the average level of the VIX over the past one and five years is 17. And its average over the past 10- and 20-year periods is approximately 21.
Going into last week, our volatility forecasting was already calling for a return to a more normal volatility environment. So while we don’t now necessarily believe the market is entering a new period of high volatility, it is something we will be studying and evaluating closely over the next few days. Regardless, our goal, as always, is for Risk Assist to make the appropriate and transparent risk management decisions for the clients it serves.
The Risk Assist portfolios also traded last week and have similar exposures to the GAIN portfolios as noted above, but with slightly lower weightings to the more volatile investments and slightly higher weightings to broad-based index positions.
SPEND: Real Spend
Trading volumes in the markets have begun to rise from their relatively low levels as of late, with Friday showing huge signs of increased volume and market volatility. Dividend-paying sectors such as utilities and REITs were hit hard on Friday. Within Real Spend portfolios, international positions outperformed domestic holdings during the week.
During times such as late last week, it is useful to remember that Real Spend’s spending reserve feature is designed to help manage significant volatility and its impact on a retirement income strategy. The spending reserve can serve as both a volatility buffer and a source of liquidity to meet current expenses.