Financial market volatility: do not lose sight of the big picture

26 January 2016

For financial markets, this year started off the wrong foot.

After a disappointing, but relatively unexciting December for both developed and emerging markets (except China which had a positive month), market volatility picked up sharply during the month of January. Global equities sold off and entered into double digit loss territory. In addition, gilt yields fell as demand for safer assets rose. Financial market volatility increased above its historical average, but did not reach as high as the peaks seen during the sell-off in August 2015.

Performance of selected equity indices (rebased at 100)

As is usually the case in financial markets, there was not a single cause that led to the market sell-off but there are rather a number of factors that might have contributed to it.

First of all, continued sharp falls in oil prices contributed to negative market sentiment. Falling oil (and commodity prices in general) is sometimes associated with declining global economic activity, which is expected to hit capital expenditure and corporate profits and thus equity market returns.

Second, after the Federal Reserve went ahead with increasing short-dated interest rates for the United States in December, investors are starting to accept the new reality that for the first time in almost a decade, some central banks are taking a step back and might not continue supressing volatility through additional monetary easing measures.

The third and final point is China. Most market commentators were quick to conclude that the recent sell-off stems from the slowdown of the world’s third largest economy. While Chinese markets were the first to experience a sell-off at the beginning of the year, this does not necessarily mean that this alone caused global markets to fall.

China is as equally affected by negative sentiment as the rest of the world, but its fundamentals are not as bad as gloomy markets suggest. The country still runs a current account surplus, has large foreign reserves and has sufficient political stability and financial firepower to continue pursuing structural reforms to rebalance the economy and deal with high debt burdens in sectors such as real estate and local government. Whilst China has featured dominantly in the market sell-off, no one can conclude with absolute certainty that China was the main trigger.

There are certainly reasons to be concerned as the economy is facing major headwinds over this year and the current business cycle (length of the economic recovery since the last recession) has been unusually long. However, it would be premature to suggest that we are heading into a global recession and even if this was the case, predicting this beforehand is next to impossible. Doom-Sayers are often jokingly said to have correctly forecasted nine out of the last five bear markets.

Periods of asset price volatility and falling markets can be uncomfortable, especially when one is in the middle of it. Hence, it might be tempting to occasionally make tactical decisions (i.e. short-term) and hope that this can prevent one’s portfolio from suffering losses during downturns.

In the short and medium term, however, market movements are largely unpredictable. If trustees tried to regularly call the markets and adjust their asset allocation every time market sentiment shifts, the only certain thing would be elevated trading volume and higher transaction costs. There is no guarantee that markets will be anticipated correctly and trustee boards rarely have the appropriate governance structures in place to make such decisions. Even if an investor was right slightly more often than he/she was wrong, over longer periods, gains would likely be offset by losses incurred when mistiming markets plus transaction costs incurred each time the portfolio was traded. This suggests that an investor must be right significantly more often than half of the time for this strategy to pay off, something very few trustee boards (with appropriate governance structures) have managed historically.

Therefore, tactical asset allocation is likely to distract from working towards long-term goals in terms of asset-liability management and reaching a full funding position. Trustees should focus predominantly on long-term strategic asset allocation, based on less volatile long-term capital market expectations and construct a well-diversified portfolio that does not have disproportionate exposure to a single region or asset class. By spreading the exposure, the portfolio should hold up better in the long run, even if in the short run certain asset classes or regions perform better or worse than the others. In a diversified portfolio, losses in one region or asset class tend to offset gains in others.

In finance it is often suggested that additional risk is rewarded with a higher expected return. A pension scheme with a long time horizon is often able to take above average risk as there is generally time to recover from temporary losses (subject to covenant strength). Should trustees feel that their scheme is unable or unwilling to endure periods of heightened market volatility, they should consider reducing exposure to risky assets such as equities in their strategic asset allocation instead of making knee-jerk decisions while in the eye of the storm. Your investment consultant will be able to help you in quantifying the amount of risk that your scheme is running and help you to set a strategic benchmark that targets the right amount of expected risk for your circumstances.

There are multiple solutions that have been successfully adopted by some of our clients, including mechanistic triggers (for which volatility can be beneficial), liability driven investment, diversified growth funds, etc that can be used to manage and reduce asset-liability volatility (see our previous note on this subject). Capita can help with building resilient long-term portfolios and put in place volatility-reducing investment strategies. Trustees are encouraged to contact their usual investment consultant for further information.

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