Market Timing Volatility: More Dangerous than Volatility Itself
In the last three weeks, volatility has spiked and global equity and fixed income markets have declined. Global equity market declines have taken back all of the year’s gains and then some. While the CBOE Volatility Index (VIX) has risen to near 25, it remains below levels seen earlier in the year of 37 and well below past crises levels. The recent declines leads us to ask the critical question: What has fundamentally changed in just the last few weeks to justify this market sell-off?
Global growth remains on track for another positive year, accompanied by exceptionally strong corporate earnings. However, while next year should see positive economic growth, a slight moderation in pace is anticipated. Likewise, earnings growth next year is expected to be solid, albeit just not as robust as this year. The earnings outlook was already expected by the marketplace and recent earnings expectations over the last few months have been encouraging, appearing stable to even improving in some areas. That being said, while the fundamental picture remains supportive, several times now during the year investors have struggled with rising interest rates, trade complications, and the late stage of the economic cycle in the US. These issues combined with additional pressures from geopolitical events have only added to investors’ uncertainties, reducing the margin of error for missed expectations and increasing short-term volatility potential.
Rising interest rates continue to be a concern as consumers, companies, and the US government must pay higher interest on newly issued debt. We expect that because the shift in rates is from a very low base, it appears manageable; therefore, the recent rise in interest rates has not changed our forecast. We maintain our base case for modestly higher rates over the near-term due to continued Federal Reserve rate hikes, the Federal Reserve’s balance sheet runoff, growing deficit borrowing, and reduced foreign investment. We expect that the market will experience a moderate but not dramatic rise in rates due to our forecast for modest growth and inflation in the US. In addition, we believe the Federal Reserve’s actions are credible and indicators point to modest inflation, supporting a reasonable pace of Federal Reserve rate increases. Lastly, we expect interest rates to be tempered by longer-term structural limitations from aging demographics, automation, and pension and insurance company investment demand for yield.
We do, however, recognize that US trade uncertainty has been a mixed bag, with progress in trade relations between the US, Mexico, and Canada, but with less clarity and increasingly heated rhetoric between the US and China. Tariffs can be a headwind to growth, but we do not anticipate that tariffs will be sufficient to derail this current economic environment. There is a risk of increasing inflationary pressures, but as we have noted previously, inflation in the US remains relatively low and some pressure from tariffs should not spark sustained price gains. Unfortunately, it is unknown when we will have greater clarity on trade with China. With the timing and nature of possible outcomes uncertain, we choose not to speculate on how the negotiations will evolve, and would rather monitor developments closely. We believe that remaining diversified across a broad range of regions, industries, and high quality companies will provide the appropriate downside protection for long-term investors during this uncertain time.
We have acknowledged the signs of late cycle dynamics several times this year, and continue to expect increased volatility going forward, though again from a low base. The market, always forward looking, is coming to terms with the understanding that while conditions are still healthy, very strong margins, a surge in earnings, and accelerating economic growth likely will not be repeated next year. The added pressures of Fed tightening, higher rates, and trade wars will reduce room for error going forward, as missed expectations will likely be strongly punished and periods of volatility more frequent. Because these headwinds are playing out in an environment of heightened political tensions globally, we find that these challenges are amplified in the public sphere while the positives tend to be downplayed.
Despite the advanced age of this cycle, we see little indication for recession in the near term. The Fed’s tighter monetary policy and higher interest rates are legitimate headwinds to monitor, but the modest pace is coming off historically low rates and is during a robust period of growth. Periods such as the first few weeks of October always remind us of the value in diversification as well as the importance of staying the course. In our mind, attempting to market time volatility remains much more dangerous than volatility itself.