Today’s episode is on volatility and has been recorded for institutional and professional investors.
Hi everybody. This is David Lebovitz Global Market Strategist at JP Morgan Asset Management.
I figured today we would talk about a topic that has been front of mind for investors really for the better part of this cycle. And that’s volatility.
But interestingly enough, you know, it’s really been the lack of volatility that investors have recognized and kind of not complained about. I mean, very few people would complain about low-volatility but really kind of grabbed onto and focused on as one of the results of monetary policy which has been historically easy really at the global level for the better part of the past 10 years.
You know, it’s interesting the higher hindsight is obviously 2020, you know, when we look back at what central banks have done over the course of this cycle. We’ve seen interest rates held at zero, around the world we’ve seen policy rates pushed into negative territory in places like Europe and Japan.
You know, this broader policy dynamic has coincided with the onset of quantitative easing. Quantitative easing used to be something that really you only saw come out of the bank in Japan.
Quantitative easing is now the cool thing to do and arguably you are not part of the cool Central Bank or club if you are not out there buying trillions of dollars of your own government’s debt maybe even corporate debt.
In the case of Europe, you know, quantitative easing, zero interest rates all of this has conspired and really put downward pressure on the overall levels of volatility over the course of this cycle.
And 2017 really sticks out like a sore thumb, on average during the past 39 years the S&P 500 usually falls by about 14% from peak to trough during the course of the year.
However in 2017 the largest drawdown we saw was a mere 3%. Now that dynamic did kind of resolve itself in 2019 and so far - 2018 and 2019 so far but volatility still feels a bit lower than one would expect at this point in the cycle.
And so when we look at where the world is headed we think that there is reason to believe that volatility is going to pick up going forward. You know, 2018 solid year for the U.S economy. Not quite as solid a year for the global economy but you really had the benefit of fiscal stimulus in tax reform in the U.S cropping up those broader global growth figures.
We definitely got a taste of volatility at the end of last year as the S&P 500 fell by nearly 20% from peak to trough during the fourth quarter. But, you know, kind of concerns that led to that adverse market reaction seemingly resolved themselves in the first quarter of 2019 as the government shutdown ended. And economic growth not only in the U.S but in Europe and around the world as well ended up looking better than had been expected at the turn of the calendar year.
It feels like despite the progress that we made in the first quarter we are backtracking a little bit. Growth looks set to soften here globally in 2Q. And with the softening in global growth and at the same time what we are seeing is a re-escalation of trade tensions and elevated policy uncertainty. Not only as it pertains to trade policy but as it pertains to monetary policy as well.
You know, coming into this year you had a lot of economists expecting the federal reserve would hike rates in 2019. Consensus now seems to be for one maybe even two interest rate cuts between now and the end of the year.
So, you know, we don’t really know what to expect in terms of trade with China. We don’t really know what to expect in terms of trade with Mexico. The economy is softening in Q2 and that softening could be exacerbated if trade tensions take a more adverse turn.
And meanwhile it’s not really clear how the Federal Reserve is going to react to this broader dynamic. Will they stay intact? Will they cut? They probably worn hike but the bottom-line is that there is a massive amount of uncertainly out there and uncertainty tends to lead to higher volatility.
So we do think given interest rates have moved higher over the past couple of years and interest rates tend to leave volatility by about two years.
Given that interest rates have trended higher here over the past couple of years, given this broader uncertainty as it pertains to the trajectory of growth and the outlook for both monetary and trade policy -- we do expect that volatility will be higher between now and the end of the year than it has been on average during prior years of this expansion.
But while we can sit here and talk about volatility and central banks and these big structural themes until we’re purple in the face, the question for investors really is, okay, so what do you do about it? You know, what can I do in my portfolio to take advantage of volatility moving higher or if not take advantage play a little bit more defense than perhaps I have up until this point in the cycle?
You know, generally speaking we tend to see that higher volatility is good for hedge funds we’ve done some work in our Guide-To alternatives looking at historical hedge fund returns by level of the VIX. We find that 20 to 25 on the VIX really tends to be the sweet spot for hedge fund returns. And as you see volatility regimes move higher that tends to lead to even more Alpha being added by the underlying manager.
So higher vol, lower correlations, wider dispersion all of the things that we think will come to fruition over the next couple of quarters lend themselves quite nicely to better perform inside of hedge funds certainly relative to what we’ve seen up until this point in the cycle.
So while we think hedge funds is one way that investors can play offense in a higher volatility environment, you know, a lot of it comes down to playing a good defense and protecting your assets during periods of choppy markets.
Our expectation for higher volatility has led us to really focus on assets that generate a bit more income than the average bear so we still like carry assets within fixed income. Things like high yield continue to look attractive from where we sit and that’s directly tied to the fact that we think the underlying trajectory of earnings remains relatively healthy at the current juncture.
Thinking about equity markets, you know, tech, consumer discretionary, the Feng stocks they have had a great run up until this point in the cycle. But historically those types of names have derived most of their return from capital appreciation rather than income.
You add on top of that the fact that tech fields like GroundZero when it comes to trade tensions and the prospect of additional government regulation we’re gravitating away from sectors like that and focusing more on things like financials, energy and real estate which have historically derived the greater share of their overall total return from the dividend that they pay out.
In other words they are less reliant on capital appreciation, less reliant on prices moving higher and more reliant on that stream of income that these underlying companies are paying out.
So we think that there are ways of playing defense in public markets things like high yield, things like financials, real estate, maybe some energy stocks if you can stomach some of the volatility on a day to day basis.
On the private market side of thing, you know, we touched on hedge funds those are a kind of a hybrid of public and private markets. We see a lot of opportunity in infrastructure at the current juncture.
You know, infrastructure pays a relatively solid stream of income but provides the potential for capital appreciation if the economy keeps growing. So to me, you know, an incremental dollar today can really be well spent in the infrastructure space.
We’re a little bit worried about private credit. We have a lot of people come to us and say, you know, should I be adding the private credit or should I be setup an allocation to private credit at this point in the cycle?
As we’ve discussed on prior episodes we think that there is some structural risks to private credit as an asset class. And as a result we’ll be more focused on implementing distressed strategies, you know, taking managers, incorporating managers who can play a little bit in high yield as the credit cycle continues to run. But then can take advantage of a rollover in that credit cycle and more attractive prices in the distressed area when the business cycle inevitably runs its course.
So the bottom-line here is that volatility has been low but it doesn’t feel like low-volatility is here to stay. It does feel like vol is accelerating going forward. And in an environment of rising volatility, you know, from where I sit the best offense is really a good defense.
So thanks for tuning in today. Hopefully you will join us again next time and let us know if you have any questions or feedback. We hope to see you again soon.
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