The transition from liquidity-powered markets for risk assets to those influenced a lot more by fundamentals was never likely to be smooth, as it involved changes to drivers of investor behavior and market flows. Yet, despite this year’s unsettling spikes in high-frequency, two-way market moves, the right investment strategy is to “look through” the volatility.
Given the events in markets over the last few years, this approach has two main implications for long-term investors: On portfolio allocation, it calls for them to make either implicit or explicit calls on macroeconomic policies in the U.S., Europe and China; and, on specific exposures, it requires them to take a view on key emerging trends.
This year has been characterized by the kind of stock market movements that hadn't been seen for a while. As an example, Bloomberg Markets reported last week that there had already been three times as many moves of 1 percent or more in the S&P 500 this year than there were for the whole of 2017.
This increase in two-way price moves was preceded in 2017 by a highly unusual combination of market calm, strong performance and favorable asset-class correlations for conventional investment portfolios. Together, these conditions delivered one of the best years on record for traditional investors, both on a standalone basis and when risk-adjusted.
Against this background, investors shouldn't treat this year’s volatility as a strange phenomenon. Instead, they should think of it as payback for a period when a more normalized level of volatility was heavily repressed by significant non-commercial flows, including consistent buying of securities on the part of some large central banks and cash-rich corporates. This allowed markets to continuously sidestep fluid economic, geopolitical and political factors. As a result, market corrections became less frequent, less severe and a lot shorter in duration.
Low volatility is not the only thing that investors have de facto borrowed from the future. They have also borrowed growth, and not just through the rise in debt that has enabled a range of additional economic and corporate activities. The resulting impact on markets was turbocharged by investor conditioning to buy every dip and served to decouple more elevated market pricing from more sluggish fundamentals. That could be sustained as long as the non-commercial suppression of volatility remained strong, both in actuality and in investor perceptions.
This delicate balance is being redefined so far this year. But instead of experiencing a significant deterioration in fundamentals that pulls down elevated asset prices, markets are navigating a reduction in the potency of the volatility suppressors.
The central banking community, led by the Federal Reserve, continues to slowly transition away from the financial repression regime that has dominated its thinking and actions since the global financial crisis. Unlike during other bouts of volatility since the crisis, the end of quantitative easing purchases by the Fed, actual and anticipated balance-sheet reduction by the European Central Bank along with Fed rate hikes have not been accompanied so far this year by soothing words from central bankers to counter volatility spikes.
Investors should look through market volatility as long as it does not cause major technical dislocations and damage market functioning. They can draw comfort from the limited disruptions associated with this year’s collapse in short-vol trades and Bitcoin prices, as well as from the relatively limited widening in credit spreads.
All of which raises questions about the longer-term positioning of investment portfolios given the transition in market volatility.
From an asset-allocation perspective, this involves a call on the success of two more regime transitions that are also ongoing: in global growth dynamics and trade interactions, and in the rebalancing of macro-policy in systemically important countries.
As I have argued, the world economy needs much stronger pro-growth leadership after benefiting from the fortunate coincidence of four largely unconnected drivers of economic expansion: policies in the U.S., natural healing in Europe, a soft landing in China, and rebounds from shocks in Brazil (political), India (demonetization) and Russia (commodities). For example, the U.S. needs to build on positive developments by supplementing recent measures with a productivity-enhancing infrastructure program. Europe should do more to implement structural reforms, rebalance its fiscal-monetary mix and strengthen the regional economic and financial architecture.
Investors' assessments of the probability of such changes speak directly to their view on how, where and when the gap between market prices and fundamentals will be closed. The orderly convergence of fundamentals to market prices, thereby validating them, is the best outcome. And that is not the only big call investors face. In considering allocations to specific sectors and securities, they also need to take a position on what are likely to be a handful of defining phenomena over the next few years -- for example, in tech, regulation, geopolitics and the alignment of the global economy.
Putting aside geopolitical risk, my evaluation of these issues points to three main takeaways that feed into investors’ assessment of how much risk they should take and where they should take it.
- There is a 65/35 probability of a successful navigation of the three major regime changes in markets, policy and growth. These odds reflect the view that the current phase of tit-for-tat tariffs by China and the U.S. is not the prelude to a full trade war but, instead, part of a negotiating process toward trade that is fairer and more free.
- It will be hard for Big Tech to avoid some regulatory backlash. The ongoing repricing of the sector will have a differentiated effect, as those perceived widely to be broad suppliers of personal data (such as Facebook) are potentially more affected than those believed to be indirect suppliers (such as Amazon and Netflix).
- With an increasing number of sectors being disrupted -- specifically, by the accelerating advances in artificial intelligence, big data and mobility -- the relative performance of companies in the bigger corporate universe will be substantially influenced by how well they harvest the power of machine learning, data processing and updated consumer interfaces.
Here is the silver lining of the current bout of greater volatility for investors able and willing to respond: Days of particularly pronounced market moves, both up and down, tend to be associated with high co-movements in sectors and individual companies. As such, they also provide attractive opportunities to reposition for longer-term themes.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."
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