A volatile perspective?

28 August 2015

During the third week of August 2015, due to lingering concerns about a slowdown in China and associated weakness in commodity demand, there was a marked pickup in financial market volatility.

On Monday, 24 August, a large sell-off in Chinese mainland equity markets led to the sharpest single day decline (-8.5%) since the financial crisis. Other markets followed suit, prompting falls that ranged between – 5.4% for the Eurostoxx and -3.9% for the S&P 500.

Over the week as at close of play 26 August 2015, the Shanghai Composite Index was down by -26.7%, The S&P 500 fell -7.7%, -8.7% for the FTSE 100, -9.4% for the Eurostoxx 50 and -7.9% for the MSCI Emerging Markets Index. Liquidity, which was already suppressed due to seasonal reasons, decreased further and the short-term implied volatility spiked – increasing the cost of downside protection.

Since the end of May, the greatest losers are the Shanghai Composite Index (-33.1%) and the MSCI Emerging Markets Index (-21.6%) while developed market losses are ranging between -7.9% (S&P500) and -12.6% (FTSE 100).

In the short run, such movement can cause panic and bring back painful memories of the Financial Crisis. All major markets seemed to have edged close to correction territory over the last week, while both the Shanghai Index and overall emerging markets are now in bear market territory – defined as a downturn of 20% over at least two months.

Certain investors do not seem to fully believe the narrative of a global recovery and China’s need to rebalance its economy seemingly served to confirm this point. Compared to the aftermath of the Financial Crisis, where emerging economies’ growth could offset a prolonged downturn in the developed world, these investors now question whether growth in countries such as the United States and the United Kingdom can offset the effects of China’s slow down on emerging countries – especially as the European recovery is modest and riddled with political risks.

Taking a long-term view, however, large intra-year declines are not uncommon. Over the last 35 years, markets have experienced a 16% intra-year fall on average; however, in 27 of these years, markets then recovered to finish up on the year.

Since the Financial Crisis, markets have gotten used to low volatility, courtesy of unprecedented central bank intervention. Investors need to brace themselves for a return of more normal market volatility driven by economics and fundamentals as these cannot be indefinitely mitigated by monetary policy.

As we pointed out in an earlier note on volatility; we recommend our clients to concentrate on their long-term strategic asset allocation, avoid getting overly distracted by short-term volatility and refrain from the temptation of making tactical decisions without having an appropriate risk management framework in place.

Equities as an asset class tend to be volatile, which is why it historically has compensated investors with higher rates of return over longer periods of time. In the light of recent years of low volatility, current events can appear to be extreme but are in reality not that unusual. Therefore they should not, in isolation, influence previous strategic decisions on asset allocation.

We recommend clients to get in touch with their usual investment consultants should they wish to discuss their specific circumstances in more detail.

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