A month ago, I warned that volatility was likely to rise into September from the summer's more placid levels. As discussed, over the past week, both equity and bond market volatility have hit two-month highs. Looking forward, the rocky road is likely to continue in the near term thanks to investor anxiety and uncertainty surrounding three issues.
1. The uncertainty surrounding the economic recovery. Most recent economic reports (including U.S. manufacturing data and numbers out of Europe and Asia) suggest marginal improvement in the global economy, but the recovery has been uneven. This was evident in last Friday's non-farm payroll report, which showed that while the U.S. economy is stabilizing, job growth is not accelerating. In short, investors are focusing on the mixed nature of the U.S. data -- stronger manufacturing but continued weakness in jobs and consumption.
2. The uncertainty surrounding what the Federal Reserve (Fed) will do. Given the uneven nature of the recovery, the Fed will have a difficult decision as to the timing and extent of any tapering. Adding to the uncertainty, it is still unclear who is going to head the Fed in 2014.
3. The growing geopolitical uncertainty, particularly surrounding the Middle East. It's unclear how the humanitarian disaster in Syria will unfold, but growing unrest in much of the Middle East has led to a significant reduction in oil supply. The supply reduction has pushed oil prices up 25% above April lows. Should the region's violence escalate and the instability spread, higher energy prices are likely to impede the global recovery.
So what should investors do to prepare? In order to insulate portfolios amid more volatility, I advocate:
- Seeking international diversification. International stocks' cheaper valuations already reflect some fair degree of risk.
- Considering an overweight to energy companies, which can potentially act as a hedge against Middle East induced market volatility.
Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility. The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters. Diversification may not protect against market risk or loss of principal.