Opportunities in volatile markets

The new year has got off to a rocky start. The uncertainties of the political climate, including the Brexit impasse and the US Government shutdown, have been mirrored in financial markets, which continue to be characterised by high levels of volatility.

Leading global stock markets posted gains during the first two weeks of the year, but day-to-day performance was erratic – and the bounce-back was nowhere near strong enough to compensate for the disappointments of 2018.

Indeed, by any measure, 2018 was a challenging year for investors. The sunny days of 2017, when global markets rose in every month of the year, seemed a distant memory. Another round of sell-offs in December left many global markets close to or even in correction territory for the whole of 2018¹.

By the end of the year, the FTSE 100 Index was down by more than 10% compared to the start of the year, Germany’s Dax Index had slipped close to 18% and Japanese equities were around 11% lower over the same period. US equities fared slightly better, but the S&P 500 Index was still more than 6% down. And with emerging markets equities also down by more than 12%, there were no hiding places for stock market investors.

Volatility returned to markets – and most analysts anticipate that it is here to stay. At the start of 2018, the VIX index, a measure of how volatile traders expect the US market to be over the next 30 days, stood at just 10; by the end of the year, it had more than doubled, to 21².

There are many reasons for this, from the trade disputes between the US and China to the economic instability caused by Brexit. Meanwhile, rising inflation expectations have put pressure on central banks to normalise interest rates. The US Federal Reserve voted unanimously to raise rates before Christmas, suggesting more rate increases could be on the cards in the months to come.

Still, while volatility may continue, the outlook for the global economy is more positive than it may appear, providing opportunities for investors. Certainly, this is not the time to panic – as ever, taking a long-term view should see investors rewarded for their bravery.

The year ahead

The political and economic upheaval that so unnerved investors last year is unlikely to come to an end any time soon.

Certainly, it would be wise to anticipate further ups and downs in the saga of trade tensions between the US and China. At the G20 summit last November, Presidents Trump and Xi apparently enjoyed a conciliatory dinner, raising hopes that threats on both sides of an escalation in the trade war may not be followed through.

However, President Trump’s administration remains concerned about the economic threat to the US posed by China’s increasing wealth – and also has one eye on 2020’s Presidential election. So far, the Trump administration has imposed tariffs on $250 billion worth of goods, with the possibility of more to come in 2019³. This has the potential to slow the Chinese economy, and to dampen the US’s strong performance as China retaliates.

In Europe, meanwhile, the questions over Brexit persist. With less than three months to go until the UK is due to leave the European Union on 29 March 2019, the terms on which it will do so are as uncertain as ever following the Government’s failure to secure backing from Parliament for the deal it agreed with the European Union.

Potential outcomes still on the table range from a no-deal Brexit, in which the UK crashes out of the EU, to the calling of a second referendum, delaying Brexit, and potentially even cancelling it altogether.

The prospects for the global economy

At a global level, the big question is whether a downturn is on its way. By March, the global economy will have notched up its longest ever period on record without recession – but some market indicators suggest this may not last.

One signal worrying commentators is the yield curve on US bonds, which reflects investors’ expectations for interest rates over different time periods. It is currently inverted, with longer term yields lower than short term yields.

That suggests investors expect the Federal Reserve, the US central bank, to reduce interest rates in the future – the traditional response to an economic slowdown. For this reason, an inverted yield curve has been a reliable indicator of a recession.

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However, this is by no means inevitable – while the inverted yield curve is a concern, it’s not an infallible indicator. In the past, recessions have followed anywhere from nine months to four years after the market’s prediction. In any case, the signal has tended to be strongest when focused on two-year interest rates, and over this period the sections of the yield curve haven’t inverted.

In fact, the fundamentals still remain pretty strong for the US economy, at least. US consumer spending looks robust, as people benefit from very low unemployment and increasing pay growth, while tax cuts are boosting their disposable income.

If the world’s largest economy can sustain its growth, other economies will contribute too. In Europe, Brexit is distracting rather than destructive; the UK accounts for only 4% of global GDP. In any case, a happy ending for markets – in the form of a soft Brexit or even no Brexit at all – remains possible. Even in the worst case, much of the uncertainty should be resolved during the first half of 2019 – and many market analysts suggest the possibility of bad news is already priced into valuations, with UK equities looking relatively cheap.

Taking a more active approach

Rapid swings in asset prices can unnerve investors, but volatility can also present opportunities for those who can maintain their composure and focus on a longer-term time horizon.

Still, some investors may need to change tack. Volatile markets can support an active approach to investing that focuses on actively-managed portfolios over a passive approach using index trackers. That’s because in volatile markets, there can be greater disparity in the performance of companies even within the same sector, providing opportunities for fund managers to look for value as a way to generate returns above benchmarks.  Their stock picking skills rise to the fore in this environment.

The opportunities for investors

For investors able to accept higher levels of volatility, there could be plenty of opportunities in 2019. In particular, developed market equities have the potential to strengthen, while emerging markets are also in a position to bounce back, having been sold off even more aggressively in 2018.

Brexit, meanwhile, may also appeal to the brave. Though near-panic has dominated media reports and left politicians stricken, markets have been pricing in the worst-case scenarios for some time now. Yields on UK equities are close to 10-year highs – with dividends well covered by company earnings – and there is still room for upside gains should we start to see any new positive developments in Europe.

The key for investors will be to position their portfolios to weather the possible storms ahead without simply running for cover. It makes sense to maintain exposure to both developed and emerging market equities – as long as investors have a longer-term approach – but also to diversify with other asset classes too. When the outlook is so uncertain, pack for all climates.

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