What Goes Around Comes Around

|
Includes: DIA, EWC, FCAN, HEWC, QCAN, QQQ, RINF, SPY
by: BlackRock

On a recent flight to Toronto, my fellow passengers and I experienced a rather unusual landing, something the airline industry terms a "go around." We were making our initial descent and were poised to land when, suddenly, the plane pulled up and began to climb. For most of us on board, this was rather surprising and unsettling, but the pilot came over the loudspeaker to reassure us nothing was wrong and that he was going to try again. The problem: poor visibility.

As with our initial approach to the runway in Toronto, financial market conditions can at times appear tranquil even when visibility is impaired. For example, stock markets exhibited an unusual period of relative calm during the years when the Federal Reserve (Fed) was growing its balance sheet through quantitative easing and holding short-term interest rates near zero (see chart below). Even though the economic fundamentals were anything but normal and the outlook was quite cloudy, the Fed and other central banks regularly provided assurances that they would engineer a smooth landing.

Volatility on the rise

Click to enlarge

Note: The line chart shows the quarterly average of weekly implied volatility as measured by the Chicago Board Options Exchange's S&P 500 Volatility Index and the Montreal Exchange's S&P/TSX 60 Volatility Index. The dots represent the most recent data points.

Source: Bloomberg, BlackRock Investment Institute, as of April 14, 2016

However, since the Fed stopped buying bonds in late 2014 and began the process of normalizing monetary policy last December, financial market volatility has edged higher. Worries about a U.S. recession, a European banking crisis, a large devaluation of the Chinese yuan and the sustainability of the rise in crude oil prices have contributed to more violent swings in most asset classes. With the economy stuck in low gear - and investors increasingly skeptical of the central banks' flight plan and wondering how much gas there is left in the tank - uncertainty has begun to overwhelm financial markets.

Fasten your seatbelt
But looking at measures of equity market volatility today, things are eerily quiet yet again. Peculiarly, the improvement in the tone of riskier assets since the dark days of mid-February has had much more to do with bad things not happening than of an outright improvement in the fundamentals.

Furthermore, many risks are still unresolved: The outcome of the upcoming referendum on the U.K.'s membership in the European Union is highly uncertain, China has reverted to using debt issuance to moderate the economic slowdown, and the Democratic and Republican primaries in the U.S. are growing ever more heated.

Each of these concerns has the potential to unsettle markets. However, a recession in the U.S. seems unlikely for the time being, downward pressure on earnings will likely fade as oil prices firm, Canadian economic activity appears to be gathering momentum, and the Fed seems increasingly reluctant to raise rates aggressively in light of these global risks.

So while I'm not anticipating a crash landing, I expect financial markets to hit more air pockets and bounce around more as a result of this limited visibility. I find this to be especially true for the Canadian stock market, which is more exposed than most developed country exchanges to swings in natural resource prices. As such, there are some strategies investors can employ to help smooth the ride.

  • Within the stock market, investors may want to focus on minimum volatility strategies and look to companies that consistently grow their dividends.
  • As for government bonds, although they don't offer much yield, they are one of the few assets that consistently provide ballast during periods of financial market stress.
  • Another allocation that investors could consider to help diminish portfolio volatility is gold.

Source: Bloomberg.

This post originally appeared on the BlackRock Blog.