What to Make About Market Volatility
If you stand on the street corner and predict that one day there will be an accident, eventually there will be. This is very similar to those that have been saying, including me, that it is inevitable that the market endure a correction after an unprecedented rally. This is what has occurred over the last week. Adjectives were tossed around by the media including “plummet, catastrophic, violent” and other synonyms you can think of describing recent market movements.
So what really is happening? First, let’s be clear that it’s impossible to predict exactly why things occur in any markets whether they be fixed income, equity assets, commodities, or other investable assets. Short-term market movements are tough to decipher. It’s even more difficult to trade in advance of short-term market movements as the reality is no one really knows when a spike or drop will occur (nor does anyone truly know the intensity of the movement).
Fear of Inflation
With that being said, it’s evident that the market movement we have seen over the last week or so is very much driven by fears that rate increases will be more pronounced than originally anticipated based on a strong payrolls number and rising worker wages. The concern is that a strong employment picture, coupled with significant tax cuts putting more money in the hands of consumers and businesses, will lead to inflation. The resulting concern is that inflation will lead to higher interest rates which tends to be negatively received initially by investors.
The same negative reaction can be seen in fixed income markets as yields spike and prices drop. Higher inflation implies possibly higher interest rates which implies lower bond prices as fixed income positions move inversely to rising rates. Even gold and commodities have been under pressure. And bitcoin, well bitcoin, has lost over half its value in the last 60 days.
Is the fear of higher interest rates justified?
It certainly is concerning that forces are aligning to nudge inflation higher. Cutting taxes, a relatively low interest rate environment, and global easy monetary policy all work together to stimulate economic growth. Still, despite this growth focused picture, we tend to believe that the spike in rates will not be quite as pronounced some fear. There are other counterbalancing factors including globalization, unwillingness from some corporations to fully invest in economic growth from recently received tax cuts, and labor market pressures from technology innovation driving down production and service costs.
It is our view that rates inevitably will rise. What we believe is currently an overstatement is the panic and fear that have gripped some that we are about to enter into a period of abnormally high inflation resulting in interest rate increases at a higher slope. The Federal Reserve has continued to state that it is well-positioned to raise rates whenever they need to. That much was said recently by Chairman Powell, the new chair of the Federal Reserve. What he also said during his first public comments was that inflation is currently low and one cannot ignore the sentence. If inflation is low, the likelihood of rates rising quickly may not be as certain as some fear.
Equity and fixed income markets both tend to initially react negatively whenever concerns about interest rate policy arise. There is an understandable concern that corporate profits and consumer spending will be negatively impacted by higher rates. But it is also clear when looking at past interest rate increases, that the slope of the increase is what matters rather than merely that rates are rising. If rates rise at a reasonable pace and there is not an unforeseen spike in tightening, markets tend to settle down. It’s a bit like what happened during Brexit it when asset markets panicked after the Britain exit vote and then soon calmed down.
So what do I see in my perpetually cloudy crystal ball? I don’t currently see a cataclysmic decline or economic implosion. I think it would be perfectly reasonable to assume the markets might drop another 10% and that would be part of a normal correction. This includes not only equity assets but fixed income positions as well. I furthermore believe that as valuations continue high levels, volatility will become more commonplace.
Let’s be clear that everything I’ve shared is an opinion based on our careful research and thought. But it is also true that conditions and news headlines can change on a daily basis. And there is no certainty that markets will behave rationally. Movements are not always rational and sometimes triggered by the smallest of events.
In order to position portfolios for this type of market environment, one must balance return expectations with risk mitigation concerns. It’s a balance we think is important and often not a consideration for most investors. With markets near all-time highs on the equity and fixed income markets, carefully constructing portfolios to provide a profile that fits financial planning goals as well as volatility comfort levels is critical. Positioning portfolio strategies in a way that considers both upside and downside volatility is the best strategy for investing assets. And mundane as it may sound, a long-term perspective does matter what one invests in assets as short-term guesses are nothing more than that; short-term guesses.
Watching One Day at a Time
We will keep watching, assessing, and adjusting as needed. Every day there is a potential for opportunity and disaster and that is exactly why we carefully watch market movements, economic data, and other business trends. The entire research and trading team here at DWM is constantly watching and discussing news of the day. And of course, I continue to be plugged into my contacts regarding their outlook for markets and economies.
I trust this provides some insight into our thinking. Please do let me know if you have any questions.