Dirk Hofschire’s key takeaways
- The Fed, Japan, and China have driven volatility in the stock and bond markets.
- Bond investors should expect lower returns than they’ve been accustomed to.
- Market volatility is going to be a little higher than it has been.
- Low inflation and supportive monetary policies continue in the United States and other developed markets.
Dormant for several months, market volatility resurfaced as the Federal Reserve reiterated its intention to taper quantitative easing policies later this year if the economy and employment rates continue to improve. Not only was there increased stock market volatility, but bond markets also experienced significant movements as rates jumped to levels not seen in more than a year.
Lars Schuster, institutional portfolio manager for Strategic Advisers, Inc., a Fidelity Investments company, and Dirk Hofschire, senior vice president of Asset Allocation Research, discuss this and more in their monthly market update.
Schuster: Let’s review this past month in the markets.
Hofschire: We’ve seen a major spike in market volatility. It started in late May and began in the bond markets. Yields started to go up—then volatility spread into global currency markets and eventually into stock markets around the world. It has been a rough patch of performance in the last few weeks. Almost everything went down at the same time. Some of the categories on the worst performers’ list were some we’ve become used to this year: emerging markets, stocks, and some of the commodity categories. But the big defining characteristic of this downturn was that bonds went down as well. Almost all categories fell as bond yields went up. There were few places to hide in this recent bout of volatility.
Schuster: Were the key reasons for the volatility policy driven or were market and economic conditions at play?
Hofschire: I think most market watchers attribute the market volatility first and foremost to the Federal Reserve and to some of the comments Chairman Bernanke has been making about ending the quantitative easing program and what that timetable might be. He hinted at this in May, gave some more concrete ideas in June, and I think this is the biggest part of market volatility, at least as a near-term catalyst.
We’ve been in a very low-volatility, calm environment for quite some time. This has been a function of a lot of liquidity, quantitative easing, some stability in the global economy, and a lot of cheap financing from the liquidity—enabling people to buy riskier asset classes, such as riskier bond categories. Everything went up at the same time, not just stocks; even Treasury bonds and other things that aren’t always correlated went up together. So I think what’s happened in the last few weeks is that we’ve seen an unwinding of some of those liquidity and other conditions and everything has moved down at the same time. We shouldn’t be surprised, because we were unwinding during the previous period.
I think three main reasons have caused the market volatility. One is the Fed and the fact that some of the short-term quantitative easing may be going away sooner than people had anticipated. The second reason is that Japan has traditionally been a low-volatility type of economy—its bond and currency markets have been a source of funding for carry trades and other riskier plays around the globe. Now, Japan has become a source of volatility, as it has seen tremendous fluctuation in its bond and currency markets. The third thing is that China has also become a source of market volatility. China’s economy has had trouble gaining traction, as we’ve talked about in the past. One of the things that’s happened recently is authorities have shown that they’re going to start tightening some of the credit, particularly the shadow financing, that had grown over the past several years. This was a double whammy for a lot of emerging markets and commodities—things that are tied to China.
So when you put these three things together, all at once we have a very rapid unwinding of positions in asset categories that had worked pretty well over the last few months and, in some cases, the last few years. And as markets do, sometimes that momentum can be very quick and can lead to some wild swings.
Schuster: Should this environment be a concern to bond investors? And does it portend a future negative environment for bonds?
Hofschire: As we’ve talked about in recent months (and for even longer), today’s low-yield environment should be tempering the return expectations for bond investors. It’s harder to get returns from low-yield environments and there’s a higher risk if interest rates do go up. Rates, even after moving up some, are still low when you look at them historically, and they’ll still probably go up. So the key now is to think about what the outlook is. We’ve had an abrupt move, we’ve unwound a lot of the quantitative easing; people were thinking it was going to go on forever and were making investment bets accordingly. So now I think the outlook is back to, “How quickly will the economy grow?” and the answer will depend on how much interest rates go up and over what period of time.
It’s important to remember that thinking about the end of quantitative easing does not necessarily mean that even a year from now, the Fed is going to begin to tighten and tighten dramatically. I think the economy is still gradually improving, which should put upward pressure on interest rates. But the Fed is probably going to be in no hurry to make dramatic increases in interest rates.
As a reminder, this recent backup in long-term bond yields is the third time in the past five years that long-term bond yields have gone up one percentage point, or a hundred basis points, in a relatively short period of time. On the other occasions, long-term bond yields didn’t keep going up; they actually started to go down.
The big picture for bond investors is, yes, they probably need to expect lower returns than they’ve been accustomed to recently. But it doesn’t mean that this recent move-up in yields is going to lead to another near-term spike and then another one and a really large spike in interest rates over the immediate term.
Schuster: Bonds have been in an upward-moving market for many decades. Now they’re near historically low yields. So going forward, do bonds still really make sense for a portfolio?
Hofschire: Yes, bonds do still make sense. They still can add stability and defense to a portfolio, which are very valuable. And that doesn’t change when rates start going up. So it’s important to remember that even if interest rates go up, bonds are not as risky as stocks. And historically, these characteristics have helped bonds provide some protection for a portfolio when stocks have gone into a bear market or when there have been economic recessions. And I’d expect that these characteristics will continue to make that true going forward. But I think it is a good point: We’re in a different situation now than we’ve been in over the past 30 years, in which rates are probably not going to be continually declining.
So the risk/return profile of high-quality bonds differs, which does lead to thinking about portfolio construction on the fixed income side a little differently. Investors may want to consider some ways to diversify their portfolio—for example, by having multisector bond exposure rather than only interest-rate-sensitive bonds in their portfolio. You may also think about having some actively managed strategies so if there is higher volatility, you can move around and potentially take advantage of some of the volatility and the relative valuation moves in the market. But as a whole, bonds still need to be a prime component of a diversified portfolio. Investors may need to work harder than they have in the past to try to get that diversification.
Schuster: What’s driving U.S. stocks, emerging market stocks, and other stocks around the world these days?
Hofschire: In the United States, we didn’t experience a huge drop in stocks, although we did get something of a sell-off in June. But it’s not necessarily abnormal to have a period of slightly higher volatility after big gains. If interest rates keep going up, that does put some pressure on some areas of the stock market. But if interest rates are going up because the economy is improving, we think it is still going to be OK over the medium term.
When you turn to some other areas of the world, it’s a different picture. I think China is a good example of a very different story and where there’s been some fundamental change. The move by the Chinese authorities to try to rein in the massive credit expansion is probably the right thing to do over the medium and long term to make sure the risks of a financial crisis don’t become too high. But in the near term, that leads to China’s having a weaker outlook amid an economy that is already having trouble gaining traction. So we think China is sliding into a late-cycle phase of the economic cycle and that’s really a riskier outlook—and not just for China’s economy. It has implications for Southeast Asia, for other developing economies, and for many commodity producers around the world that have depended on the Chinese growth story. So the stock outlook is not universally negative, but it’s certainly become more mixed when you look around the world.
Schuster: What’s an investor to do with all this information?
Hofschire: I expect that we’re not going to immediately go back to the period of ultra-low market volatility that we’ve had in recent months—or in the past couple of years. I do think volatility is going to be a little higher than it has been, but that doesn’t mean it’s going to be the extreme we’ve seen in the last few weeks. The monetary policy uncertainty, not just in the United States, but in Japan and China, is probably going to lead to higher volatility.
You also have to remember that markets can move faster than fundamentals. So during these wild fluctuations, remember what has changed and how it should impact your investment strategy. The way I look at it today: We still have some improving areas of the global economy. In the United States and other developed markets, we still have low inflation and supportive monetary policies. So there are going to be some winners and losers in that environment among different asset classes, but it’s not a terrible backdrop overall from a diversified portfolio standpoint.