As we enter into the closing stages of 2018, we will inevitably start seeing the regular ‘year in review’ and ‘year ahead’ commentaries.
But the tone of the conversation is different this year, and the exceptionally low volatility market that commentators were reflecting on in 2017 is no longer the main topic of discussion.
Up until the end of the third quarter this year it appeared the story of 2018 was going to be about the continued divergence of US stock market performance from the rest of the world, in large part driven by the Facebook, Amazon, Apple, Netflix and Google-heavy technology stocks, as well as the continued low volatility environment despite a blip early in the year.
But as stock market returns in October have shown us, there is a crack in the facade that the Faang stocks are infallible, and as a result, investors are going to need to be prepared for a more volatile environment moving forward.
But in the recent sell-off, correlations have picked up as the technology stalwart Faang stocks led the broad market sell-off, which in turn saw volatility spike again.Back in 2017, and even large parts of 2018, the CBOE Volatility Index, also known as the market’s ‘fear gauge’, which captures expectations for future volatility based on prices in the options market, was a hot topic.
Sometimes referred to as ‘picking up pennies in front of a steamroller’, the much-talked-about ‘short the Vix’ trade netted some investors enormous returns. But this trade blew up with the first onset of volatility in 2018, forcing many of the exchange-traded products allowing retail investors to access this trade to close after being nearly wiped out overnight.
While less public, many institutional investors including hedge funds were hit hard on the futures markets as well. But what led to this exceptionally low volatility throughout 2017 and much of 2018, despite heightened political uncertainty and stretched valuations?
The economy was performing strongly, risk assets were still supported by monetary policy, and corporate profitability was high on the back of tax cuts – in short, all conditions that support equity markets. But strong performance in equity markets does not necessarily mean low volatility.
In fact, these conditions were in place going back much further than 2017, and most bull markets have seen volatility at much higher levels. This is where the stories of low volatility and divergence in the performance of US markets converge.
In its year-end commentary for 2017, index providers S&P Global pointed to “record low correlations” between index constituents, which “indeed may be seen as a causal factor” for the low volatility environment.
As such, while there were certainly a number of market-moving events over this period, market participants, and indeed whole sectors, reacted in different ways, with some seeing gains and others losses. In this way the big winners offset the weakest performers, which in aggregate resulted in dampened volatility.
But in the recent sell-off, correlations have picked up as the technology stalwart Faang stocks led the broad market sell-off, which in turn saw volatility spike again. What is most important here is the strong performing Faang-led technology stocks are noticeably weakening.
While interest rate sensitive sectors have been struggling for much longer as financial conditions continue to tighten, the upward trajectory of tech stocks is no longer enough to wash out the poor performers, and volatility looks here to stay.
Perhaps most importantly, what does this regime change mean for how investors should be positioned moving forward? With the return of volatility, broad market exposure earning attractive returns is not likely to continue, and of increasing importance will be finding the best managers able to navigate this environment.
While we will maintain our defensive outlook, which includes hedges and exposure to defensive assets like US investment grade bonds, as well as alternatives that have low correlations to traditional asset classes, there will undoubtedly be opportunities that come with an increase in volatility. But we need to be selective with the risks we take, and recognise that a higher volatility environment is likely here to stay.
Eugene Philalithis is portfolio manager of Fidelity Multi-Asset Income
