Making Sense Of Market Volatility
September 8, 2015
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On Aug. 21, the Dow Jones Industrial Average entered a correction, falling 10% from its most recent peak, and reminded investors what volatility looks like after almost four correction-free years. While volatility exposes weaknesses in the market, in my opinion it also reveals the strength of high conviction managers who are skillfully navigating the market. Active management and smart beta strategies seek to surpass the “market averages” offered by traditional benchmarks, providing the potential not only for higher returns, but also for a smoother ride.
At Invesco, that’s what we seek to do for investors: Offer high conviction strategies that help people navigate volatility and achieve their financial goals.
Here, I’ve gathered opinions from several of our senior investment leaders across equities, fixed income and alternatives, discussing their view of market volatility and how it affects — or doesn’t affect — the opportunities they see.
Rob Waldner, Chief Strategist and Head of Multi-Sector, Invesco Fixed Income
China’s central bank cut key policy interest rates Aug. 24 to help calm markets after its recent currency devaluation set in motion a cascade of Chinese and global stock market turmoil. There may be some speculation that these changes to monetary policy may be the start of a form of quantitative easing (QE), however, we at Invesco Fixed Income do not view the People’s Bank of China’s (PBoC) latest moves as a broad monetary program along the lines of QE. While QE would be aimed at “getting ahead” of economic slowdown and deflation, we believe the Chinese authorities appear to be merely treading water, injecting sufficient liquidity to replace lost liquidity due to recent currency interventions. In other words, the authorities appear to be responding to recent market movements, but not more.
The unintended consequence of the foreign exchange regime shift in China to a dirty float from a peg is requiring the PBoC to sell US dollars on a very large scale. Most evidence points to large, steady capital outflows from China since the currency regime change that has forced the authorities to intervene in the foreign exchange market to prevent weakening of the currency. The mechanical reality of this policy is that China needs to raise US dollars via US Treasury sales in roughly the same magnitude as their currency intervention activity. We believe the PBoC has been selling US Treasuries to support this intervention, and that this has been one of the drivers of Treasury price action in recent days. US Treasuries over the course of the past few days have not rallied materially in the face of equity weakness and, in fact, have traded with a persistent higher yield bias.
We see no immediate end to the capital flows out of China and anticipate that the Chinese authorities will continue to intervene in the near term to support their currency. This should keep upward pressure on US Treasury yields in the near term.
We remain cautious on emerging markets, particularly Asian currencies and credits. The position-driven movements in global markets since the renminbi devaluation in August have created attractive opportunities in some markets where the fundamentals are positive but corrections have driven spreads higher. Invesco Fixed Income favors domestically focused US investment grade and high yield securities. Spreads are attractive and the fundamentals of the US economy remain solid, in our view.
Clas Olsson, Chief Investment Officer, Invesco International and Global Growth Equities
Explaining the market’s recent action is not central to our process, which is focused on identifying the most attractive companies from an earnings, quality and valuation perspective. That said, monetary and fiscal stimulus by Europe, Japan and China in the past three quarters seems to have fuelled expectations that growth would accelerate in the second half of 2015 and into 2016.
While Europe and Japan have seen some economic benefits from these policies, their better growth has been primarily driven by a weaker euro and yen. While the euro and yen have become more competitive, the yuan (due to its peg to the US dollar) has become less competitive. Despite efforts by the Chinese government to stimulate growth, their economy has continued to slow.
Future global growth expectations appear to be in a process of resetting, leading to higher volatility. We would not be surprised to see higher volatility sustained until the market digests lower global growth expectations.
As disconcerting as volatility may be, we believe it tends to create long-term opportunities for our shareholders. It’s rare to find a thriving business at a compelling valuation when everything is going right; those valuations typically occur when fear dominates the market. On a stock-by-stock basis, we see this recent decline as a buying opportunity. From a regional perspective, our process is finding more opportunities within Asia and Latin America as we have seen an indiscriminate sell off in emerging markets. From a sector perspective, we are finding more ideas within consumer staples, health care and some quality cyclicals such as technology and industrials.
We don’t try to predict macro environments, but as active managers who seek to consistently take advantage of volatility in the markets, we welcome the increased volatility as it is generally favorable for our quality growth style and as it expands our opportunity set.
Juliet Ellis, Chief Investment Officer of Invesco US Growth Equities
The current sell-off has been driven by both technicals and fundamentals — and it can become circular.
From a fundamental perspective, actions taken in China demonstrate that despite published economic data, officials in China are concerned about the risk of a hard landing. If currency devaluation spreads to other countries, the risk of default rises and sentiment moves to risk-off. From a technical perspective, the market is and has been “uneasy” with the uncertainty around the Federal Reserve’s strategy and pace for raising rates in the very near future, making it vulnerable to a sell-off. The US small and large-cap markets have been rising steadily since late 2014 with only minor pull-backs, so a correction seems reasonable.
My team thinks a buying opportunity is developing, but we’re reluctant to call a specific bottom. As this correction has pulled the markets to a flattish return, we could be setting up for a healthy fourth-quarter rally. In terms of industries, we think restaurants, software and health care equipment and services are attractive. We would not be buyers of biotech due to valuation concerns even after this pullback.
We continue to expect the US economic cycle to steadily progress into 2016 driven by improved housing, high consumer confidence and better employment. We do not think a US recession is likely.
Kevin Holt, Chief Investment Officer, Invesco US Value Equities
Often, market volatility can lead to value opportunities as company fundamentals and attractive valuations are typically ignored in a sell-off, and even quality companies fall with the rest of the market. Currently, we’re assessing company fundamentals and valuations on a stock-by-stock basis to see whether there are any attractive opportunities that fit our approach. Those assessments will vary based on the type of value strategy — there are many ways to be successful, and intellectual independence is a core value across our teams.
Invesco’s US Value complex includes four broad strategies. Each has a distinct approach to evaluating companies:
- Our relative value strategies look for companies that are experiencing a positive catalyst and are inexpensive relative to the market, applicable sector and their own history.
- Our deep value strategy is a contrarian approach that utilizes a long-term investment time horizon (typically, four to five years) to take advantage of significant discounts of the current stock market price and the underlying value of a company, using different valuation metrics depending upon the growth or cyclical nature of the business.
- Our flagship dividend value strategy closely evaluates companies’ total return profile, emphasizing appreciation, income and preservation over a full market cycle.
- Our intrinsic value strategies use a traditional intrinsic value approach in which the goal is to create wealth by maintaining a long-term investment horizon and investing in companies that are significantly undervalued on an absolute basis, using consistent valuation assumptions for all businesses.
The portfolio managers for these four distinct value approaches are staying true to their processes and capitalizing on value opportunities as they find them.
Ron Sloan, Chief Investment Officer of Invesco Global Core Equities
Global markets have become extremely volatile due to an old-fashioned growth scare in developed countries, as the opportunity to find organic earnings growth has become quite limited. Companies that were benefitting from fast-growing emerging market economies (for example, commodity-related industries) have seen a meaningful decline in demand in the past few years, and the trend does not appear to be slowing.
For the market to continue its multi-year climb, I believe it will have to be driven by earnings growth, and not valuation or central bank maneuvers. And, new leadership in the market will be required. Earnings estimates are collapsing, and should be expected to continue to drop into 2016. “Where can you find earnings growth?” is the question my team focuses on every day, but particularly now. While we are not expecting the US economy to enter a recession, meaningful earnings growth is likely to be limited to a few select segments of the market.
Groups that we find encouraging at this point include home builders (and their derivative beneficiaries), “old” tech companies (versus a few very high profile and arguably overpriced internet-related companies) and select consumer cyclicals (several retailers, for example). While we are quite constructive on some high-quality financials, we believe that, at this stage of the market, it is too early to be aggressive for the broader sector. We are also cautious in some areas of recent strength such as autos, as we believe inventory build-up has likely created a headwind for near-term earnings.
A key differentiator for us is identifying companies that are investing in their business, and focusing on long-term growth as opposed to financial engineering (stock buybacks) for short-term results. We believe we are entering a stage of the market that will demonstrate greater differentiation between companies, particularly in regards to quality of management — as well as differentiation among investment managers’ processes and how they approach the market.
Scott Wolle, Chief Investment Officer, Invesco Global Asset Allocation
Recent market volatility took many investors by surprise. As risk-parity managers, my team aims to stay ready for the events that no one is expecting. August’s elevated volatility does not affect our investment approach.
Our balanced-risk approach seeks to mitigate the effects of negative surprises and take advantage of opportunities in an efficient and effective way. The aim is to provide investors with a smoother ride through the three phases of the economic cycle — inflationary growth, non-inflationary growth and recession. We strive to achieve this objective in three primary ways:
- Each asset class exposure — stocks, bonds and commodities1 — is built by considering the key drivers of return specific to that asset class.
- We combine these asset classes based on the amount of risk they may contribute to the portfolio. (Whereas other strategies, such as 60/40 portfolios, allocate a certain percent of capital to each asset class, regardless of their risk contribution.) We believe true diversification is key to limiting downside risk.
- Markets move in cycles, so we make tactical adjustments, seeking to take advantage of these cycles, allowing us to be more adaptive to the current environment.
When we build our balanced-risk portfolios, we think first about economic outcomes and which assets could best defend or take advantage of each. We next consider the liquidity, diversification benefit, and evidence of a risk premium for each asset. We believe this results in a portfolio that has the opportunity to prove resilient in challenging environments, ample liquidity, and diversification.
David Millar, Head of Invesco Multi Asset
The events of the past few days have underscored the unpredictability of financial markets and the importance of portfolio diversification. With an uncertain market outlook, which could include several catalysts for increased volatility, the Multi Asset team believes it’s important for investors to include sources of returns in their portfolios that could complement, but behave independently of, the traditional stocks and bonds they may already own.
The team believes the best way to achieve this type of diversification is to break away from the focus on asset class constraints that often distract from fundamental long-term thinking and focus on finding good investment ideas. The team has the flexibility to search globally for these ideas across a wide array of asset classes, geographies, sectors and currencies. This allows us to invest in things that may work, even when traditional markets may not. For example, investing in volatility as an asset class — by buying volatility instruments — could potentially increase the defensive exposure in the portfolio, even as traditional safe haven assets come under pressure.
We have an absolute return mandate that includes a target return of 5% above three-month US Treasuries over a rolling three-year period, with a target volatility of less than half that of global equities, over the same rolling thee-year period. We seek to achieve these targets by investing in a portfolio of ideas that the team believes work best together. At the same time, we also evaluate each idea in the context of possible but highly unlikely events (not unlike the one we just experienced). Why does this matter? Because as we just saw, in this type of environment, we believe it’s important not only to align a portfolio with what we think will work, but also to structure the portfolio for when we might be wrong.
Bernhard Langer, Chief Investment Officer, Invesco Quantitative Strategies
China’s attempts to shore up its domestic growth through currency devaluations and aggressive monetary stimulus have unnerved many investors around the globe. As a result of this and other macroeconomic events like the drop in oil prices and the uncertainty surrounding rate lift-off in the US, equity markets have sold off sharply and volatility has spiked. On August 17, the VIX was around 13; just one week later, however, it had jumped to nearly 412 – a level last seen in October 2011 during the eurozone sovereign debt crisis.
These extreme short-term gyrations can be quite stressful, but are an excellent time to reflect, not react. The investing horizon for most investors is measured in years (if not decades), not days. Therefore, it is most appropriate – and fiscally responsible – to consider the implications of risk over a time frame that extends beyond today’s headlines.
Within Invesco Quantitative Strategies, we have been managing risk as well as return for over 30 years. Throughout that time we have quite deliberately used models that forecast risk over a longer horizon in all our equity strategies. We believe this has led to more stable risk profiles in those strategies because long-term average volatility is simply easier to predict – and therefore manage – than short-term volatility.
Dan Draper, Managing Director of Global ETFs
Periods of market volatility offer investors the opportunity to reflect on their core investment strategies. It’s easy to feel comfortable in a bull market, but when market turbulence strikes, we all become better acquainted with our appetite for risk. Investors who rely on market-cap-weighted benchmark products go in with the understanding that, for better or worse, they will earn the returns of the market. That’s great when stocks are surging. But as the past week reminds us, market-cap-weighted strategies also expose investors to the full risks of the market.
Smart beta strategies are based on the premise that market prices are not perfectly efficient and that alternative weighting and factor exposure can exploit these inefficiencies. One of the advantages of smart beta strategies is that they offer so many diversified sources of return, and can deliver favorable risk-adjusted returns across many different market environments.
Right now, investors are focused on volatility. Our low volatility portfolios may help those who want to participate in the equity markets, while increasing the potential for downside protection. Even for the most risk-averse investor, maintaining some equity exposure – even during market corrections – can be important over the long-term to protect against inflation and potentially increase purchasing power.
Regardless of market conditions, smart beta exchange-traded funds (ETFs) may offer a versatile, transparent way to help meet investors’ objectives. Of course, not all low volatility products are alike and, depending on the provider, they can offer very different risk/return profiles. It’s important that investors consider ETF providers with a time-tested track record of performance in all market conditions.
Ingrid Baker, Portfolio Manager, Emerging Market Equities
The long-term transition of China from an investment-driven growth engine to a consumption-driven one remains intact, but challenges remain. For one, consumption relies in part on a healthy investment environment to provide jobs in construction sectors, whether for residential/commercial properties or public works. Secondly, demographic trends in China are worrisome as the working age population continues to decline, putting pressure on support ratios as the country pays back the “youth dividend” from the so-called “One-Child Policy” that coincided with China’s generation of significant growth.
That said, with anecdotal evidence from publicly listed manufacturing companies that higher wages are putting pressure on margins, against a backdrop of sustained low deflation, mass-market consumers are gaining purchasing power. This, all else equal, should allow the expansion of the Chinese middle class to continue. Urbanization in China lags well behind North Asian neighbors, providing a visible path for consumption growth over the long term. In the more near term, the government also retains capacity to fight slower growth with monetary easing and some selective fiscal stimulus, particularly in urbanization-related infrastructure such as mass transit, water management and social housing.
My team is finding bottom-up opportunities in China, preferring companies that have exposure to a growing consumer class. This includes selective internet stocks, as well as sectors such as health care, insurance, and rail construction that have meaningful secular growth prospects. Some stocks in other Asian markets, such as Korea and Taiwan, also have attractive China operations that provide good exposure to the country and have management teams that have experienced slowdowns in their own markets and so should be able to navigate macroeconomic headwinds in China. We are underweight banks as interest rate liberalization and declining asset quality seem likely to impair historically high returns on equity.
Walter Davis, Alternative Investments Strategist
The recent sharp sell-off in global equity markets has focused investors on the importance of holding diversifying investments that can help cushion their portfolios during times of market stress. Given their unique nature, alternative investments are proving to be useful tools to help investors weather the current market storm.
Alternatives have historically outperformed equities during periods of equity weakness, while equities have historically outperformed alternatives during periods of equity strength. This has proven to be the case as alternatives lagged equities during the post crisis bull market, while outperforming equities on a year to date basis in 2015.3
There are a wide variety of alternative investments, with some playing offense and helping build investor wealth, and others playing defense and helping investors preserve wealth. Here are three:
- Market neutral funds. For investors looking to cushion their portfolio against increased market swings and mitigate downside risk, market neutral funds might be an appealing option. Such funds trade related equities on a long and short basis, such that the fund has close to zero net exposure to the market and a beta that is close to zero. The key to generating a positive return is security selection – determining which equities to go long and which to go short. Market neutral funds seek to generate positive returns across all market cycles and have historically generated modest returns with low volatility.
- Long/short equity funds. These funds allow investors to participate in the equity markets on a hedged basis. Such funds combine both long and short equity positions in a portfolio, while typically being net long to equities. As a result, fund performance should track that of the overall equity market, but the fund would be expected to underperform during a rising equity market (due to losses on the fund’s short equity positions), and outperform during a falling equity market (due to gains on the fund’s short equity positions).
- Global macro funds. Global macro funds invest across the global equities, fixed income, currencies and commodity markets on a long and short basis. Such funds invest opportunistically and have the ability to determine what markets they want, and don’t want, to participate in. Furthermore, because these funds have the ability to invest on both a long and short basis, they have the potential to achieve profits in both rising and falling market environments.
I think alternatives should be a core part of every investor’s portfolio because they can do things that traditional stocks and bonds can’t. If investors use the recent market volatility as an opportunity to explore the world of alternatives, I believe that will be a positive outcome of this uncertainty.
1 Under normal conditions, the strategy invests in derivatives and other financially-linked instruments whose performance is expected to correspond to U.S. and international fixed income, equity and commodity markets. However, the performance of the asset classes cannot be guaranteed. The derivative investments and enhanced investment techniques (such as leverage) used by the portfolio are subject to greater risks than those associated with investing directly in securities or more traditional instruments.
2 Source: CBOE
3 As of Aug. 24, 2015, every Morningstar Alternatives Fund Category is outperforming the S&P 500 Index on a year-to-date basis.
Volatility measures the amount of fluctuation in the price of a security or portfolio over time.
Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.
A dirty float is a floating exchange rate system in which a government or central bank occasionally intervenes to affect the value of its country’s currency in a managed fashion.
A currency peg refers to the policy of tying one currency’s value to another currency.
Deflation is a decrease in the general price level of goods and services that occurs when the inflation rate falls below 0%.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.
Stocks are related if they are driven by the same fundamental factors; for example, two stocks from the same industry.
Long positions make money when an investment rises in price.
Short positions make money when an investment falls in price.
Beta is a measure of risk representing how a security is expected to respond to general market movements.
A hedge is an investment made to reduce the risk of adverse price movements in a security by taking an offsetting position in a related security.
Past performance is no guarantee of future results.
Diversification does not guarantee profit or eliminate the risk of loss.
Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
Stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Smart Beta represents an alternative and selection index based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both in active or passive vehicles. Smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The fund’s return may not match the return of the index.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com/fundprospectus.
All data provided by Invesco unless otherwise noted.
Invesco Advisers, Inc. is an investment advisor; it provides investment advisory services to individual and institutional clients and does not sell securities. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.
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Making sense of market volatility by Invesco Blog