During the recent summer months, equity markets made steady progress in a relatively serene trading environment. This reflected a stable outlook featuring slow but steady economic growth ahead for the developed economies. This benign macro-environment has changed of late, resulting in increased volatility.
There are three factors that have caused this shift. First, there has been a heightened vigilance of the US Federal Reserve, as it considers a second interest rate increase (the first was in late 2015). It is clear that the “Fed” intends to add another 25 basis points to the indicated overnight interest rate, and could well do so before the end of the year. This would bring the indicated rate up to a range of 0.50 to 0.75%, projecting the image of a more “normal” economic environment. That environment currently features ongoing steady growth, low unemployment rates, and no visible threat of inflation. As the calendar winds down to the end of 2016, this Fed increase will be highly anticipated and will keep equity markets somewhat volatile until the decision is announced.
Second and perhaps of more important concern is the looming US Presidential election, now less than a month away. This election cycle has produced two of the most controversial and least popular candidates in recent history. We believe that equity markets are factoring in a win by Democratic candidate Hillary Clinton, who is both more experienced and competent than her Republican opponent, Donald Trump. If the market forecast is wrong, and Trump wins, this could result in a dramatic increase in market volatility.
Third, the lingering effect of the recent Brexit vote in the UK and its impact on the future of both the UK and the European Union is a contributing factor. This scenario could jeopardize the slow but positive economic growth that this important region had been experiencing. The timing and manner in which the UK would extract itself from the EU has created an aura of uncertainty. Equity markets hate uncertainty, be it at the macro or the corporate level.
Increased volatility can however still result in positive returns for investors. We have been living with heightened periods of volatility ever since the US residential mortgage crises scenario began to unfold almost a decade ago. There are two ways to deal with this volatility. The first is the temptation to “time the market”. This requires selling equities on strong days and buying back in when one believes that things have hit bottom. This is much harder to do than it seems. Picking just where the market tops and bottoms are is very difficult in “real time”. The great majority of active investment managers that attempt this strategy fail. The second method is to do the fundamental research on what you believe are the most suitable companies to invest in, and then try to buy in during timing of the UK’s Brexit strategy, and will have likely seen another minor interest rate hike from the US Fed. Indeed, interesting opportune down cycles. Buying good companies cheaply, and then holding them as long as they deliver, is the strategy that we prefer.