Low Volatility: How Long Can It Last?

Transcription

1 Veronica Willis Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Low Volatility: How Long Can It Last? January 30, 2018 Key takeaways» In 2017, the U.S. stock and bond markets experienced low volatility, despite political uncertainties and various geopolitical events.» We don t expect this low volatility to last. Tighter central-bank policies, increasing geopolitical risks, and decreasing co-movements among certain asset classes all could contribute to increased volatility this year. What it may mean for investors» We recommend that investors avoid becoming complacent with market conditions, and we outline some proactive investment steps an investor might consider taking in a portfolio to prepare for potentially higher volatility this year. Last year, U.S. stock and bond prices fluctuated less than they had in years past, contributing to low levels of market volatility. We believe that central-bank liquidity and better-than-expected global economic data contributed to the lower levels of volatility. This low-volatility environment can be encouraging for investors who are concerned with wild price swings in their investments. However, complacency stemming from the view that markets will not experience volatility based on recent activity could expose investors to the very risk they are attempting to avoid. We recommend that investors avoid becoming too complacent with market conditions as there is the potential for a pickup in volatility in the coming years. In today s report, we outline some proactive steps an investor might consider taking in an investment portfolio to prepare for potentially higher volatility this year. Low volatility was a major market theme last year as asset prices marched to new highs that were seemingly unchallenged, despite political uncertainties and various geopolitical events. One measure of U.S. stock-market volatility is the Chicago Board Options Exchange Volatility Index, or VIX. The VIX, a measure of the expected equitymarket volatility as determined by put and call prices on S&P 500 Index options, trailed lower in 2017 and remains well below its historical average Wells Fargo Investment Institute. All rights reserved. Page 1 of 10

2 Chart 1. U.S. stock market volatility has trailed lower in recent years 70 S&P 500 Index volatility Average 60 Index level Peak to trough drawdown 0 0% -10% -20% -30% -40% -50% -60% '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 Calendar year S&P 500 Index drawdown Lowest drawdown since 1995 Sources: Bloomberg, FactSet, Wells Fargo Investment Institute, December 31, Past performance is no guarantee of future results. The VIX is not the only way to gauge domestic stock-market volatility. Chart 1 shows that the peak-to-trough drawdown for the S&P 500 Index in 2017 was shallower than we have observed historically. Years of shallower drawdowns typically have coincided with periods of lower volatility. Low volatility was not unique to the U.S. stock market. Domestic bond market volatility also decreased last year with 10-year Treasury yields trading in a tighter-than-normal range. Chart 2. Ten-year Treasury yield trading range has narrowed in recent years 8% 7% 6% Yield trading range 5% 4% 3% 2% 1% 0% '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 Sources: Bloomberg, Wells Fargo Investment Institute, December 31, Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 2 of 10

3 What could cause low volatility to continue? One might have expected the elevated levels of economic and political uncertainty to increase volatility in financial markets. Yet, various factors contributed to the low levels of volatility seen in Greater transparency, coupled with quantitative easing measures from central banks around the world, contributed to this low volatility. Additionally, improving or steady global economic data have helped to keep volatility levels at bay. The Federal Reserve (Fed) has raised interest rates and started to reduce its balance sheet holdings in a very gradual way. Markets seem at ease with the pace, especially as economic data have improved. This gradual approach and higher level of transparency and consistency have enabled the domestic stock and bond markets to price in anticipated actions, leaving less movement from shocks or surprises. Central bank bond-buying measures in most of the world have helped to increase liquidity, support asset prices, and smooth volatility. These programs also have helped to raise household and corporate cash. Notably, liquidity, compared to short-term liabilities, has increased over the past few years and is at multiyear highs for households and businesses, suggesting that investors have enough cash on the sidelines to buy when the market dips. All these factors help to smooth volatility and support asset prices. What are the risks for an increase in market volatility? Both the U.S. stock and bond markets performed well in 2017, encouraging investors to continue adding exposure. Markets are supported by a stable global economy, but the risks for a pickup in volatility remain. Higher U.S. interest rates and a smaller Fed balance sheet should reduce the new cash in the economy. Other central banks around the world are approaching the same monetary-policy stage. The European Central Bank is currently tapering its asset purchase program, and we anticipate an end to the program as the eurozone economy improves. As central banks start normalizing their policies, there should be less new cash available for spending and for investing. As liquidity diminishes, investors may be unable to increase exposure when financial markets dip, and that could lead to a rise in volatility. We believe that investors should avoid becoming too complacent as there is the potential for a pickup in volatility in the coming years to historically more typical levels (as we outlined above). We already see that the Fed s normalization of monetary policy has slowed the buildup of new cash in the economy. The question remains how much longer will investors cash stockpiles continue to prompt quick buying on dips? While short-lived market pullbacks continue, volatility could remain low. However, volatility is unlikely to remain low indefinitely. Low volatility is not a leading indicator for market performance, and there is no way to predict a specific event that will trigger an increase in volatility. Investors can watch for clues, including how the bond market responds to negative surprises. Differences between the Fed s forecast and the market s expectations for interest-rate hikes beyond 2018 could be a trigger. Additionally, market responses to ongoing geopolitical risk and slowly increasing inflation expectations could help to create more volatility in financial markets Wells Fargo Investment Institute. All rights reserved. Page 3 of 10

4 Investment implications Equities should continue to benefit from underlying fundamentals like global economic and earnings growth, and we expect new highs in U.S. and international equity markets this year. U.S. equity markets also should be supported by federal tax reform. We continue to favor cyclical sectors, like Consumer Discretionary, Financials, Industrials, and Health Care, as they are likely to benefit the most from policy reform and an increase in economic growth. We believe that international equities also should benefit from global economic improvement. With that said, the path higher in equities may have more price swings than it did in We believe that investors should be proactive in aligning their equity exposures with their long-term target allocations today. In fixed income, rate hikes by the Fed have led to higher interest rates on the short end of the yield curve, while longer-term rates have remained more contained (despite recent increases following tax reform). This has led to a flattening of the yield curve. Consequently, we have a neutral view of bonds across the maturity spectrum. We believe that investors should remain broadly and globally diversified within fixed income, while focusing on higher-credit-quality bonds, which generally should have less volatility than lower-quality issues. We also favor Treasury Inflation-Protected Securities (TIPS) as an affordable way to protect against a low-probability shock from inflation. Chart 3. Diversification may reduce downside risk Peak to trough drawdown (%) '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 ' S&P 500 Index Hypothetical MGI 4AG without Private Capital Portfolio Sources: Morningstar Direct, Wells Fargo Investment Institute, December 31, Hypothetical 4AG (Four Asset Group) Moderate Growth & Income (MGI) without Private Capital portfolio is composed of 3% Bloomberg Barclays U.S. Treasury Bill 1-3 Months, 11% Bloomberg Barclays U.S. Aggregate Index (5-7 year), 6% Bloomberg Barclays U.S. Aggregate Bond Index (10 year+), 6% Bloomberg Barclays U.S. Corporate High Yield Index, 3% JPM GBI Global Ex-US TR USD Index, 5% JPM EMBI Global TR USD Index, 20% S&P 500 Index, 8% Russell Mid Cap TR USD Index, 6% Russell 2000 Index, 5% MSCI EAFE GR USD Index, 5% MSCI Emerging Market GR USD Index, 5% FTSE EPRA/NAREIT Developed TR USD Index, 2% Bloomberg Commodities Index, 3% HFRI Relative Value Arbitrage Index, 6% HFRI Macro Index, 4% HFRI Event Driven Index, and 2% HFRI Equity Hedge Index. Hypothetical and past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 4 of 10

5 It may be tempting to assume that it will be possible to diversify a portfolio once volatility returns, but attempting to time the market is usually a risky practice. We recommend that investors consider the effects of volatility within the context of a diversified allocation. Chart 3 shows that, over a horizon that includes both high and low volatility, a hypothetical diversified allocation may not lose as much value as an allequity allocation. This is because other components of the portfolio have not always moved in the same direction as equities over long periods of time. A diversified portfolio may not make the highest returns during a period of strong optimism but, over the long term, diversified allocations can mitigate some of the volatility that a more concentrated portfolio typically reflects. In this way, a diversified allocation has the potential to provide more consistent and smoother returns than an investor may experience in a single asset class. Attempting to smooth out the ride for long-term investors over their investment time horizon is important as it reduces the temptation to abandon a diversified allocation when one asset class is outperforming or underperforming others during a shorter period of time Wells Fargo Investment Institute. All rights reserved. Page 5 of 10

6 Economic Calendar Date Report Estimate Previous 1/30/2018 S&P CoreLogic CS 20-City NSA Index /30/2018 S&P CoreLogic CS 20-City MoM SA 0.65% 0.70% 1/30/2018 S&P CoreLogic CS 20-City YoY NSA % 1/30/2018 S&P CoreLogic CS US HPI NSA Index /30/2018 S&P CoreLogic CS US HPI YoY NSA % 1/30/2018 Conf. Board Consumer Confidence /30/2018 Conf. Board Present Situation /30/2018 Conf. Board Expectations /31/2018 MBA Mortgage Applications % 1/31/2018 ADP Employment Change 185k 250k 1/31/2018 Employment Cost Index 0.50% 0.70% 1/31/2018 Chicago Purchasing Manager /31/2018 Pending Home Sales MoM 0.50% 0.20% 1/31/2018 Pending Home Sales NSA YoY % 1/31/2018 FOMC Rate Decision (Upper Bound) 1.50% 1.50% 1/31/2018 FOMC Rate Decision (Lower Bound) 1.25% 1.25% 2/1/2018 Challenger Job Cuts YoY % 2/1/2018 Nonfarm Productivity 1.30% 3.00% 2/1/2018 Unit Labor Costs 1.00% -0.20% 2/1/2018 Initial Jobless Claims k 2/1/2018 Continuing Claims k 2/1/2018 Bloomberg Consumer Comfort /1/2018 Markit US Manufacturing PMI /1/2018 Construction Spending MoM 0.40% 0.80% 2/1/2018 ISM Manufacturing /1/2018 ISM Employment /1/2018 ISM Prices Paid /1/2018 ISM New Orders /1/2018 Wards Domestic Vehicle Sales m 2018 Wells Fargo Investment Institute. All rights reserved. Page 6 of 10

7 Economic Calendar (continued) Date Report Estimate Previous 2/1/2018 Wards Total Vehicle Sales 17.30m 17.76m 2/2/2018 Change in Nonfarm Payrolls 185k 148k 2/2/2018 Two-Month Payroll Net Revision -- -9k 2/2/2018 Change in Private Payrolls 180k 146k 2/2/2018 Change in Manufact. Payrolls 21k 25k 2/2/2018 Unemployment Rate 4.10% 4.10% 2/2/2018 Underemployment Rate % 2/2/2018 Average Hourly Earnings MoM 0.30% 0.30% 2/2/2018 Average Hourly Earnings YoY 2.70% 2.50% 2/2/2018 Average Weekly Hours All Employees /2/2018 Labor Force Participation Rate % 2/2/2018 Factory Orders 0.50% 1.30% 2/2/2018 Factory Orders Ex Trans % 2/2/2018 U. of Mich. Sentiment /2/2018 Durable Goods Orders /2/2018 U. of Mich. Current Conditions /2/2018 Durables Ex Transportation /2/2018 U. of Mich. Expectations /2/2018 Cap Goods Orders Nondef Ex Air /2/2018 U. of Mich. 1 Yr Inflation % 2/2/2018 Cap Goods Ship Nondef Ex Air /2/2018 U. of Mich Yr Inflation % 2/5/2018 Markit US Services PMI /5/2018 Markit US Composite PMI /5/2018 ISM Non-Manf. Composite /5/2018 MBA Mortgage Foreclosures % 2/5/2018 Mortgage Delinquencies % Source: Bloomberg, as of January 25, Wells Fargo Investment Institute. All rights reserved. Page 7 of 10

8 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing. Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund. Diversification cannot eliminate the risk of fluctuating prices and uncertain returns and does not guarantee profit or protect against loss in declining markets. Definitions Bloomberg Barclays U.S. Aggregate Bond Index is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities. Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB= or below. Included issues must have at least one year until final maturity. Bloomberg Barclays U.S. Treasury Bills (1-3M) Index is representative of money markets. Bloomberg Commodity Index is a broadly diversified index of commodity futures on 20 physical commodities, subdivided into energy, U.S. agriculture, livestock, precious metals, and industrial metals sectors. Commodity weights are derived in a manner that attempts to fairly represent the importance of a diversified group of commodities to the world economy. Chicago Board Options Exchange Volatility Index (VIX) reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide. HFRI Relative Value Index maintains positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative, or other security types. HFRI Equity Hedge Index maintains positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations, and valuation ranges of typical portfolios Wells Fargo Investment Institute. All rights reserved. Page 8 of 10

9 HFRI Macro Index is composed of a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency, and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods. Although some strategies employ RV techniques, macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments rather than realization of a valuation discrepancy between securities. HFRI Event Driven Index maintains positions in companies currently or prospectively involved in corporate transactions of a wide variety including, but not limited to, mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance, or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated and frequently involve additional derivative securities. Event driven exposure includes a combination of sensitivities to equity markets, credit markets, and idiosyncratic, company-specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative) with the realization of the thesis predicated on a specific development exogenous to the existing capital structure. JP Morgan Global Ex United States Index (JPM GBI Global Ex-US) is a total return, market capitalization weighted index, rebalanced monthly, consisting of the following countries: Australia, Germany, Spain, Belgium, Italy, Sweden, Canada, Japan, United Kingdom, Denmark, Netherlands, and France. JPM EMBI Global Index is a U.S. dollar-denominated, investible, market cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt. While products in the asset class have become more diverse, focusing on both local currency and corporate issuance, there is currently no widely accepted aggregate index reflecting the broader opportunity set available, although the asset class is evolving. By using the same index provider as the one used in the developed-market bonds asset class, there is consistent categorization of countries among developed international bonds (ex. U.S.) and emerging market bonds. MSCI EAFE Index is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index. Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000 Index. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

10 Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 10 of 10