Goodbye tapering, hello volatility

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Ian Heslop, Portfolio Manager of the Old Mutual North American Equity Fund

Now that the US central bank has abandoned monetary stimulus, volatility is on the up

For many fund managers, 2014 was a year to forget. A staggering 90% of global fund managers underperformed their respective indices. Wild fluctuations in style volatility, a migration from value to quality companies as investors became more risk averse, and a move generally from unstable returns to momentum investing, left the majority of active stock pickers frustrated.

Seemingly, overall market volatility remained low. The US Federal Reserve, despite reducing its degree of monetary stimulus through tapering, poured sufficient liquidity into the system to help dampen the effects of share price fluctuations.

The VIX volatility index traded in a narrow band for much of the year, from a low of 12.9 in January 2014 to a high of over 25 in October 2014 when markets became jittery over how the world would look post-tapering[1]. Yet all the while, investment styles moved in and out of favour. For ‘those in the know’ volatility never went away. It was there all the time – in a different guise.

The end of the US central bank’s tapering exercise on 31 October, while seemingly already factored into share prices, with hindsight, left a trail of destruction in its wake. Since then oil has plunged, copper fallen and equities and bonds have been subjected to wild gyrations. Simply coincidence? Or, more likely, the inevitable effect of the world economy no longer being able to rely on the largesse of the US Federal Reserve.

So is volatility here to stay?

The VIX is now trading in line with its long-term historic average. Yet history tells us it can go much higher – think back to 2008, the start of the financial crisis, when the VIX reached over 70. Or when the credit rating of the US economy was downgraded from AAA to AA+ in the summer of 2011 and it spiked up to over 40. Theorists tell us that volatility is usually at its most prominent at the end of a long-bull run. Is this where we are in the cycle, in its final stages? The S&P 500’s winning streak has lasted six years already. Could we be about to witness the seventh?

The benefits of a falling oil price are hugely beneficial to the US economy and the US consumer in particular. It would appear that consumers are already feeling better off. The University of Michigan’s consumer confidence survey reached an 11-year high in January. Experts tell us a 20% fall in the oil price equates to US$ 70 billion in consumer savings. US corporates are also set to benefit, as lower input costs should drive margins even higher. In the absence of wage inflation, who says US margins can’t go higher? Although, the strength of the dollar will likely act as headwind on profitability.

With an improving economy comes a normalisation of monetary policy, and with that, normalised volatility. The consensus view is that the US Federal Reserve will raise interest rates by the middle of 2015 and on the back of positive economic data I see no reason why this shouldn’t be the case.

The emphasis though on any tightening of monetary policy is that it must be done gradually. It’s not hard to see why expectations should be better managed. Look what happened when the Swiss National Bank abandoned the cap on its currency. The Swiss franc soared by 39% against the euro and the dollar, sending equity markets reeling and driving up the price of gold. With Mario Draghi getting the green light on full-blown quantitative easing it had simply become too expensive for the Swiss to keep buying a weakening euro.

Yet, governors of central banks can’t always be relied upon to manage expectations and, if there’s one thing markets hate, it is surprises. So it seems we need to get used to increased volatility. But if that’s the case, how do we deal with it?

The answer is, more than ever, to diversify a portfolio’s alpha. By holding a larger number of stocks for a shorter period of time, I’m able to bypass potentially problematic issues of investment style and concentration. By taking a diversified approach I aim to identify factors critical to performance over shorter periods, and to invest in a broad portfolio of stocks where these characteristics are most evident. This is not to say that this approach will not incur volatility but it should dampen it. At the end of the day we, as fund managers, all strive to achieve the same thing. To paraphrase Warren Buffet: rule number 1: don’t lose money. Rule number 2: don’t forget rule number one.

Goodbye tapering, hello volatility graph

Source: Bloomberg to end 31 December 2014.

OMGI 01_15_0110.

[1] Source: Chicago Board Options Exchange SPX Volatility Index, Bloomberg