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Why Volatility May Be A Bigger Threat Than Rates

Russ Koesterich, CFA profile picture
Russ Koesterich, CFA

Russ discusses why investors should worry less about higher interest rates and more about the volatility resulting from tighter financial conditions.

Investors are growing anxious. Most of the angst is focused on interest rates and the Federal Reserve (Fed). However, although that fear is not irrational, it may be exaggerated, as I discussed a few weeks back. All else equal, stocks can withstand modestly higher rates. The obvious rejoinder is that all else is never equal.

Rather than a marginally more aggressive Fed, the bigger threat may be the side effect of tighter financial conditions leading to more volatility. In other words, stocks can probably withstand yields of 3% on the 10-year Treasury, but a VIX stuck in the 20s may create a real headwind for equities.

Why should volatility be such a threat? Even after the recent spike, the VIX Index is only back to its long-term average. Furthermore, equity markets did quite well in the late 1990s, a time when the VIX frequently was above 20.

There are at least three counter arguments. This bull market has been largely built and sustained on cheap money; conditions are changing. In addition, the change is happening against a backdrop of extended valuations in U.S. equities. High valuations and high volatility did coexist in the late 1990s, but that did not end well. Finally, in the post-crisis world multiples are much more correlated with volatility.

Easy money

Indeed, one reason markets performed so well last year is that despite the Fed hikes, financial conditions actually eased. While the Fed was hiking, other factors - notably the U.S. dollar and credit markets - were pushing in the other direction. The net result is that financial conditions remained about as easy as they get.

Easy money and loose financial conditions are important as

This article was written by

Russ Koesterich, CFA profile picture
Russ Koesterich, CFA, JD, Managing Director and portfolio manager for BlackRock’s Global Allocation Fund, is a member of the Global Allocation team within BlackRock's Multi-Asset Strategies Group. He serves as a member of BlackRock's Americas Executive Committee. Mr. Koesterich's service with the firm dates back to 2005, including his years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. He joined the BlackRock Global Allocation team in 2016 as Head of Asset Allocation and was named a portfolio manager of the Fund in 2017. Previously, he was BlackRock's Global Chief Investment Strategist and Chairman of the Investment Committee for the Model Portfolio Solutions business, and formerly served as the Global Head of Investment Strategy for scientific active equities and as senior portfolio manager in the US Market Neutral Group. Prior to joining BGI, Mr. Koesterich was the Chief North American Strategist at State Street Bank and Trust. He began his investment career at Instinet Research Partners where he occupied several positions in research, including Director of Investment Strategy for both U.S. and European research, and Equity Analyst. He is a frequent contributor to financials news media and the author of two books, including his most recent "The Ten Trillion Dollar Gamble."Mr. Koesterich earned a BA in history from Brandeis University, a JD from Boston College and an MBA from Columbia University. He is a CFA Charterholder.

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Comments (1)

One thing you can count on is the Fed doing exactly the wrong thing at the wrong time. Remember Cramer pleading with Greenspan to halt the hikes. Alan did 5 in a row, did another after Cramer’s show. Later we learned the economy was in a recession before Alan made the first rate hike. I still think deflation is in the cards.
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