Fear not – volatility is normal

volatility

After the long period of rather calm markets in 2016-17, we predicted that from 2018 onwards, we would see a return towards more normal levels of market volatility. Swings up and down in share prices – even big moves – are normal behaviour for markets. The upside from investing in equity markets is the potential for higher returns; the downside is greater volatility, compared with holding assets like bonds or real estate. The most important thing is to keep calm and remember your long-term investment goals.

As for wider economic implications, we don’t think the current high level of market volatility is a harbinger of impending recession. Well, not before 2020 or 2021, at any rate. Unless, that is, the US and China make some major policy errors.

What the big investors buy and sell compounds volatility

In most developed equity markets professional investors – pension funds and insurance companies, hedge funds and sovereign wealth funds – make the major investment calls. They’re constantly trying to price in a wide range of economic, corporate, policy and political factors – when the outcomes of various scenarios could be very different. For example a hard or a soft Brexit matters a lot for UK share prices whereas a full blown trade war between the US and China matters much more for global share prices. How the big investors interpret potential outcomes, and the decisions they make to buy and sell certain stocks, drives much of the market ups and downs.

How the big investors interpret potential outcomes…drives much of the market ups and downs.

Elsewhere, in a digital world, social media can certainly affect certain markets like the Chinese stock markets, where retail investors are particularly important.

The technology sector has been hit particularly hard by the recent bout of market volatility. In part, this is due to the prices of technology shares having been too richly valued. The Nasdaq index has fallen well over 10% from its August peak. In the current earnings season, those tech companies who missed investor expectations were punished very sharply, while those who demonstrated that they could still create good earnings growth were more resilient.

All ears to rhetoric on rates

The people who decide the path of US interest rates – the governors at the US Federal Reserve – have told investors to expect another two to four upward moves, depending on how dovish or hawkish the particular Governor is. All the signs suggest that companies will only deliver moderate wage increases in the current environment, while technological factors will keep headline inflation under control. If the US Federal Reserve becomes more aggressive in its rate hiking, we should certainly worry. But if it remains on its current path we should not.

Meanwhile the European Central Bank (ECB) has made it clear that it will halt its quantitative easing (QE) bond buying programme at the end of the year and raise interest rates in the second half of 2019 – assuming, of course, no further shocks to global trade. Despite all the volatility in financial markets, the European economy is showing sufficient growth to ensure a gradual rise in wages and therefore inflation.

There are still some risks ahead: a disorderly Brexit in March would hurt regional activity, while the Italian government is certainly testing the system with its plans for a large budget deficit. All in all, the ECB remains reactive, not proactive, to global events. This makes us wary of European bond markets; against this sort of backdrop, European equities look to offer better prospects.

Many investors are still looking for growth in a slow growth world – with sectors such as healthcare recently attracting attention. One of the advantages of a sharp fall in share prices is the opportunity to buy attractive assets. In this environment, emerging market assets look particularly attractive.

 


This article was previously published by Aberdeen Standard Investments on 20th November 2018