Strategy & economics
Surviving extreme volatility
Strategy & economics
Surviving extreme volatility
The end of 2019 was a sea of calm for investors. Global equities were approaching the end of their strongest year in over a decade and the world economy was gathering steam after a period of weak and patchy growth.
The picture today is very different. We don’t know how long the current turmoil will last. However, it is clear that we are now in a very different market environment.
The falls we have seen in major equity markets now far exceed any of the drawbacks we have seen in the past decade. This includes the eurozone sovereign debt crisis of 2011-2012 and fears of a Chinese currency devaluation in 2015-2016. In both of these cases, US market declines stopped just short of “bear market” territory (defined as a 20% decline from the peak).
The behaviour of markets today is more akin to the period of full-blown crisis in 2008-09, with global equity indices recording their worst daily and weekly performances since that period of extreme disruption. In some ways, the speed of today’s crisis makes it an even more challenging environment. There were signs of stress in the US mortgage market well before the crisis and sharp market falls of 2008. The “credit crunch” that preceded the worst of the crisis claimed noteworthy victims, such as Northern Rock in the UK, which required rescue in 2007.
In 2020, by contrast, we have witnessed a staggeringly dramatic reversal from an all-time high to a bear market.
Volatility is exceptionally high and could remain so for some time. A look at the S&P500’s worst weeks since the mid-1980s (see table, below) shows how very large falls cluster within specific bear markets. The ongoing bear market has already achieved two entries in this grim table – and it’s not impossible it will notch up others. Previous market crises have also shown us that volatility tends to start falling from its peak before prices reach bottom; investors must become comfortable with the level of price uncertainty, before they can become comfortable with prices themselves.
High volatility has a number of practical implications. The size of new positions may be smaller than might normally be the case, to allow us to withstand larger price swings. We are also prepared to be more nimble than in a normal market environment. As this crisis unfolds, investors’ mood could move quickly and sharply between optimism and despair. While our focus is on the long term, and we are confident the economy and markets will in time recover, we may at times want to take advantage of shorter-term trading opportunities.
A big worry for investors is companies’ ability to pay back debt. There will be bankruptcies – potentially of some large, well-known companies. In this environment, awareness of risk – on all possible fronts – becomes all important.
When investing directly in stocks and corporate bonds, we will be more focused on levels of debt and the ability to meet obligations under a prolonged period of stress. When investing in funds, we will look for evidence of robust risk management and the suitability of the investment process for the changed environment.
Focus on long-term themes
One of the reasons that we favour investment in long-term themes is that the associated assets tend to prove more resistant to economic slowdowns. They reflect changes in the way we live and work that evolve over decades and are unlikely to be derailed by a recession.
What we are experiencing now is very different from a classic recession. Nevertheless, there are signs that the current crisis is in fact further focusing minds on themes that have long been important to us, including technological disruption, debt and demographics.
With consumers forced to spend more of their time – and money – online, we will continue to see technology companies benefit at the expense of more traditional business models. Debt will also be at the forefront of investors’ minds, as the crisis shines a painful spotlight on cashflow. In this environment, we expect companies with strong balance sheets and resilient revenue streams to fare relatively better.
Finally the coronavirus has, very poignantly, drawn attention again to the profound demographic shift taking place in many countries around the world, with older people accounting for an ever-growing share of many populations. This will inevitably result in higher healthcare spending in the years ahead.
Investments that we have made to reflect some of these views look relatively well positioned. The healthcare and technology sectors, for instance, have been amongst the better performing segments of the stock market. While down in absolute terms, they have outperformed the broader MSCI World Index by 9.5% and 8.1% respectively in the first quarter of the year.
The importance of diversification
Times like these remind us of the importance of diversification. Not all asset classes have suffered as badly as equities; some have even thrived amid the turmoil.
Our diversification efforts have been focused on the broad category of assets known as “alternatives”. An important criterion we look for is a low correlation with equity markets. Historically, many assets that meet this criterion have tended to perform well during periods of volatility and bear markets.
As we have mentioned elsewhere, gold plays an important role within our alternatives allocation. The precious metal also experienced high volatility in mid-March, but it was still 15% higher over the prior year, significantly outperforming equities. We continue to favour exposure to gold.
As Schroders’ commodity fund manager James Luke points out, the response to the coronavirus crisis is likely to “drive deeply negative real interest rates and increased focus on sovereign debt risks, both of which should be very positive for gold prices”.
Hedge funds are another asset class with the potential to deliver returns that are uncorrelated to equities. We have some exposure to funds that are able to profit from both rising and falling share prices. This has allowed them to protect – and in some cases even increase – value during the current turmoil. While naturally hoping the coronavirus crisis comes to an end as quickly as possible, our experience and approach will help us navigate this period of turmoil, however long it lasts.
Bear Markets: A Brief History
Global stock markets have experienced some of their worst weekly falls since the mid-1980s as a result of the coronavirus pandemic. Data for the US market (see table above) suggests that stocks tend to be higher a year after these dramatic falls.
S&P 500’s worst weeks in recent history
|Week ending||What was happening?||
6 months after fall
1 year after fall
|10 Oct 2008||Financial crisis||-18||-5||19|
|23 Oct 1987||1987 crash||-12||5||14|
|21 Sept 2001||Aftermath of 9/11||-12||19||-12|
|28 Feb 2020||Coronavirus pandemic||-11||?||?|
|14 Apr 2000||Bursting of dotcom bubble||-11||1||-13|
|3 Oct 2008||Financial crisis||-9||-23||-7|
|16 Oct 1987||Prelude to 1987 crash||-9||-8||-3|
|13 Mar 2020||Coronavirus pandemic||-9||?||?|
|21 Nov 2008||Financial crisis||-8||11||36|
|19 Jul 2002||Fallout from bursting of dotcom bubble||-8||6||17|
Source: Refinitiv Datastream
Perhaps unsurprisingly, the worst weekly performances are all associated with deep bear markets (see bottom table). Excluding the Great Depression, the worst bear markets have on average taken two years to “bottom out” and three years to fully recover. However, there have been downturns that reached bottom much more quickly – those associated with the crash of 1987 and the Cuban Missile Crisis. In these cases, markets recovered their losses within approximately 18 months.
The descent into the current bear markets has been very fast. History suggests speed could thus also be a feature of the recovery. If so, the cost of not being invested when the market turns could be high. A significant portion of the gains could potentially occur early in the recovery, as has sometimes been the case following previous downturns.
The deepest bears... and the longest: top 10 S&P 500 drawdowns since 1920
Time taken to reach the bottom, and to recover to the starting point (months)
|Name||From||Trough||Drawdown||Time to trough
|Great Depression||Sept 29||Jun 32||-86.1||34||267|
|World War II||Feb 37||Apr 42||-57.6||62||45|
|Global financial crisis||Oct 07||Mar 09||-56.8||17||34|
|Tech bubble||Mar 00||Oct 02||-49.2||25||56|
|OPEC crisis/Watergate scandal||Jan 73||Oct 74||-48.2||21||70|
|Vietnam War||Dec 68||May 70||-36.1||19||23|
|Coronavirus pandemic||Feb 20||?||-33.8||1||?|
|Black Monday crash||Aug 87||Dec 87||-33.5||3||20|
|Post WWII inventory recession||May 46||Jun 49||-29.6||37||31|
|Cuban missile crisis||Dec 61||Jun 62||-28.0||6||14|
Source: CapitalSpectator.com, as of 27 March.
Despite periodic bear markets, the long-term return from US equities remains very attractive. For the 20 year period ending in 2019, US shares delivered a total return (including both share price appreciation and dividends) of 6.1% per annum. This period includes two major bear markets (the collapse of the dotcom bubble and the financial crisis) and many smaller shocks. Rolling forward the analysis to take into account the decline in the first quarter of this year, the long-term annualised performance falls to 4.7%.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.