By Russ Koesterich
Last Thursday’s sell-off was significant in at least one way: it was the first time since 16 April that the S&P 500 moved more than 1% in a day. The three-month streak had not been equaled since 1995.
While the spike in volatility was short lived, it was the first time investors have been shaken out of their complacency since April. And as the uptick is coming from historically low levels — the bottom 1% of historical observations — it may have much further to go. Even at its peak last Thursday, equity market volatility, as measured by the VIX Index, only reached 15, roughly 25% below the long-term average.
Low volatility suggests investors are complacent and not taking into account the prospect for bad news. Indeed, there is no shortage of potential triggers for more turbulence ahead.
To begin, geopolitical risk is clearly rising. If nothing else, last week’s tragedy in Ukraine demonstrated that the unrest in the eastern part of the country is far from over. Meanwhile, we are witnessing the continued fragmentation of Iraq and now a ground war between Israel and Hamas in Gaza.
In addition, investors should be mindful of conditions in credit markets. One of the major reasons volatility has been suppressed is linked to the unusually accommodative monetary policy of the Federal Reserve and a very benign credit cycle. Should the Fed raise interest rates sooner than expected and foster a less accommodative regime, that would likely be associated with a further rise in volatility.
Even a modest pickup in volatility will feel different compared to the placid environment of the past several months. We would continue to suggest investors emphasize asset classes that provide some cushion, primarily vis-à-vis less challenging valuations. In particular, we would favor an equity mix geared toward US large caps, particularly in energy and “old tech,” and would avoid the momentum names in social media.
Last week was a good reminder of why we advocate this approach. Large caps managed to recoup their losses, while small caps — where the price-to-earnings ratio is nearly twice that of large caps — ended the week modestly lower. And more speculative sectors that look even more expensive, such as biotech, suffered the most. Last week’s action also confirms our recommendation for smaller exposure to retailers and consumer discretionary companies, which are also expensive, trading at nearly a 25% premium to the broader market. Retail sales disappointed again in June; year-to-date sales are averaging just 3.5% year-over-year growth versus 4.2% in 2013 and over 5% in 2012.
In addition, we’d still advocate bringing up international exposure, particularly in Asia. The recent improvement in Chinese economic data has provoked the beginning of a rotation back into emerging markets (EMs). Last week was the sixth consecutive week of inflows into EMs, which suggests sentiment toward the asset class is starting to turn.
It is difficult to predict what could trigger another sell-off. But as the old saying goes, “Hope for the best, prepare for the worst.” For investors, that means emphasizing asset classes and regions that offer some relative value, and that can help mitigate the impact of a market correction.
Russ Koesterich is global chief investment strategist at Blackrock
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