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Uncertainty: do markets really hate it?

It’s an oft repeated maxim that ‘markets hate uncertainty,’ so you might expect heightened volatility in the current environment. After all, the US has elected its most unconventional president in modern history – one who announces policy and conducts diplomacy via Twitter.

Jason Hollands Jason Hollands
12 May 2017
Hot air balloons over lake

North Korea has been issuing threats of an ‘all-out nuclear war’ on a weekly basis. Relations between Russia and the West have deteriorated to Cold War lows. And closer to home we are in the opening weeks of a tough and complex divorce negotiation between the UK Government and the EU, which has already turned acrimonious. The EU itself is under pressure, with a number of member states facing electoral challenges from insurgent movements.

Stock market volatility is low

Yet despite these (and other) geopolitical uncertainties – and the rising importance of politics in economic management, as the baton has shifted from monetary policy to fiscal stimulus – one of the overriding features of the current market environment is ultra-low levels of stock market volatility. This week, the VIX (Volatility Index, often referred to as the ‘fear index’ and a barometer of implied stock market volatility for the US S&P 500 Index) has sunk to its lowest level in nearly quarter of a century, closing below 10, while the S&P 500 Index itself towers at a record high.

While low volatility and buoyant markets might seem welcome on first impressions, it may also suggest complacency about risks at a time when asset prices are also high. These prices have been boosted by a tide of loose monetary policy and euphoria about expectations of a more aggressive approach to fiscal policy, helping reflate the global economy. The worry is that years of quantitative easing and ultra-low interest rates, which were only ever meant to be a form of temporary life support in the wake of the global financial crisis, have left investors anaesthetised to risk.

Is this the calm before the storm?

Not necessarily. Analysis by Deutsche Bank suggests that periods of ultra-low volatility do not necessarily signal poor future returns, but returns are generally higher following periods when volatility has been ultra-high.  There are certainly reasons for optimism, as global growth is improving and the current earnings season has seen a positive trend in profit growth. But with valuations of many markets already at the top of historical ranges, in many cases earnings need to grow to simply justify current ratings. Such valuation levels are not the normal starting point for another raging bull run.

So while it is nigh on impossible to predict short-term market movements or accurately foresee what might prompt a future correction (and when it will be), a reasonable expectation might be for a period of more muted returns after a prolonged stellar run. It is certainly important to be conscious of downside risks. For investors, there’s a good case for holding funds with a more defensive style and incorporating some exposure to absolute return funds within a portfolio.

We believe equity funds such as JO Hambro UK Opportunities and Liontrust Special Situations have a more defensive investment profile, while Invesco Perpetual Global Targeted Returns and Standard Life Global Absolute Return Strategies are good absolute return fund picks. As always, if we can help with anything investment or financial planning related, do get in touch.

Important information

The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. This does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers. Funds may carry different levels of risk depending on the industry sector(s) in which they invest. You should ensure that you understand the nature of any fund before you invest in it. Targeted Absolute Return funds do not guarantee a positive return and you could get back less than you invested, as with any other investment. Additionally, the underlying assets of these funds generally use complex hedging techniques through the use of derivative products, which can carry additional risks which may not be immediately apparent.