Volatility on the rise and how to prepare for it

In the words of European Central Bank President Mario Draghi, “We should get used to periods of higher volatility.”  

There are a plethora of factors that will increase the stock market and bond market volatility over the next several months (and years). Some of the factors are due to decreased government intervention, while other factors are more cyclical in nature.   

In regards to government intervention, the U.S. Federal Reserve has stopped their quantitative easing program and is getting closer to raising interest rates. It is projected the Fed will most likely increase the Federal Funds Rate by the end of the year at least once.  

The European Central Bank and the Bank of Japan are several years behind as they are still engaging in quantitative easing programs to help spur growth. But even with that, the anticipation is that both the European Central Bank and Bank of Japan should be on the path to raise interest rates within the next few years.  

Some of the cyclical issues include the unsustainable long-term debt in places such as Greece which will most likely not be resolved anytime soon. Their debt overload is a hangover from excessive spending, and entitlement programs will most likely need major reform as well as restructuring in order to make Greece competitive again.  

Looking at current stock valuation levels compared to the last 20 years, stock prices do not look particularly stretched or undervalued. Although, because of the rapid expansion of stock prices, there will be much less pressure than in prior years to push the stock market up.  

At the same time, bond values, especially long duration, are appearing overvalued based on the Federal Reserve’s guidance on the Federal Funds Rate. This will, over the next few years, put upward pressure on yields and downward pressure on longer-term bond prices.  

All of this makes the perfect formula for price volatility to increase as investors wrestle with the uncertainty associated with the global environment. However, there are ways to reduce the volatility within your portfolio. One of the best ways is to allocate part of your portfolio towards assets that have either zero, low, or negative correlation to the bond and stock market.  

In regards to an investment that has a zero correlation and zero volatility to the bond and stock market, there is no better place to allocate to than cash. It gives investors the flexibility to average into the stock market and bond market when there are declines.  

In regards to the typical bond market, floating rate bonds and Treasury Inflation Protected Securities (TIPS) can be a very good hedge against increasing yields. Floating rate bonds will typically give a spread to LIBOR or another benchmark. As interest rates increase the yield, the floating rate bond will also increase. Typically it strips out any interest rate risk and leaves the investor with only credit risk if they are in a non-governmental security.  

TIPS are bonds with unique investment characteristics. TIPS are issued with a fixed coupon interest rate and a fixed maturity date (e.g. 2.25 percent and January 15, 2020, respectively). But unlike traditional bonds, TIPS have a principal value that changes; it is raised (or lowered) by the Treasury each month to keep pace with inflation. As a result, the semi-annual coupon payments to investors also change because they are derived by applying the fixed coupon rate to an inflation-adjusted principal amount.  

The inflation adjustment is based on a two month lagged value of the non-seasonally adjusted Consumer Price Index for Urban Consumers (CPI-U). TIPS investors are guaranteed protection for the real value of their periodic interest payments and at maturity, their invested principal. The main driver is the inflation rate. As the inflation rate increases, the value of the TIPS bonds increase which means the converse is also true. Typically when inflation rates start to increase, interest rates will also increase which means at times TIPS can have a negative correlation to traditional bonds.  

In regards to correlation to the stock market, investments such as private equity can have a reduced correlation depending on the type of deal or deals they employ. Lastly, there are some hedge fund strategies that have very little to no correlation to the overall stock market. The best example would be a market-neutral strategy. This is a strategy undertaken by an investment manager that seeks to profit from both increasing and decreasing prices in either single or numerous markets.  

Market-neutral strategies are often attained by matching long and short positions in different stocks to increase the return from making profitable stock selections and decreasing the return from broad market movements. Market neutral strategists may also use other tools such as merger arbitrage, shorting sectors, and so on. There is no single accepted method of employing a market-neutral strategy. 

It would not be very surprising to see volatility in the financial markets increase and it would be good to at least consider mitigating or reducing some of the risks in your portfolio by either raising cash or diversifying your investments.  


Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.