Although markets always experience a degree of volatility, 2020 has seen some particularly high levels of price fluctuations. Our director of investment risk, Pacome Breton, details why this is and explains why volatility is not inherently a negative thing for investors.
What is volatility?
Volatility is a measure of the amount of price variation we might expect in a market. If there is high volatility this will tell investors that a market is unsettled and that a high degree of uncertainty is reflected in the daily price variation of the equity market. While all markets inherently have a degree of volatility at any given time, this may increase and decrease significantly based on investor confidence and outside events.
Uncertainty is often what causes volatility in the market. However, uncertainty can take different forms. It can be very obvious, such as the uncertainty of an election or a pandemic or it can be more subtle, such as an unexpected change in inflation outlook or a policy change by central banks or even political rhetoric.
There are different ways to measure volatility. The most basic one is to use the standard deviation of past returns over a specific period of time. However, this method risks an over–focusing on historic returns. The Vix Index is often the way to highlight the most recent level of volatility in the market. The Vix Index is based not on past market fluctuation but on the current level of volatility implied by the price of a basket of equity options(1) It is often the preferred method used to track volatility.
The Vix has the benefit of providing a more up–to–date measure of the current level of volatility A measure below 15 is considered moderate to low and a measure above 20/25 is considered high.
Why has 2020 seen so much volatility?
It’s easy to see why 2020 has been so volatile. The ‘known unknown’ nature of the global Covid pandemic obviously gave markets a major downturn at the beginning of the year and investors have since been trying to price–in how developments of a vaccine and public safety measures can safeguard economic value against the continuing threat of second and third waves of the virus.
More recently, we saw a degree of volatility in October ahead of the US election as investors worried about a contested result and which candidate would be in the White House for the next four years. As there was a degree of policy divergence over public investment, geopolitics and the size and nature of the next government stimulus package to help fight Covid, markets were anticipating what was going to happen and so showed a rise in volatility.
What can we expect going forward?
Very likely we will continue to see uncertainty and probably a higher level of volatility than average. The big variable is how the world responds to Covid. The virus has affected almost every aspect of our lives, from travel to consumption and when a vaccine does come, we should expect an inconsistent roll out. However, even before Covid the global economy had a number of growing volatile elements in geopolitics, well valued equity markets and record low interest rates. We should also note the emergence of technological disruption and the impact of environmental, social and highly scrutinised corporate governance considerations (ESG). These new trends were already providing elements for further uncertainty and consequently price disruption and increased volatility.
Closer to home, FTSE volatility, the value of the pound and predictions for the UK’s GDP are tied to what will happen with Brexit. The current unknowability of what a Brexit deal will look like adds to the volatility variable. Geopolitically, the future of the US China ‘trade war’ is likely to affect volatility as it weighs on market sentiment and sector outlooks across the Pacific.
Volatility is not all bad
So, should we worry? Not necessarily. While we’ve identified the key volatility variables here it’s worth emphasising that volatility, by its very nature, is never a one–way street. A look at economic trends shows us the negative impacts that markets can expect from the likes of Covid are being offset by growth in US jobs and earnings as well as optimism in economies around the world that government stimulus is protecting businesses. Further, every day brings us closer to a vaccine.
Chart showing how the S&P 500 recovered despite a spike in volatility in 2020
Source: MacroBond & Nutmeg
While sudden volatility is rarely welcomed by investors (the old saying “stocks take the stairs up and the elevator down” has some truthfulness), it is important to remember that a rise in volatility does not necessarily equate to markets spiralling into a prolonged downturn. If that was the case, we would not have seen the remarkable recovery in global markets that we did in Q3 this year and shown in the above chart. Finally, volatility is a natural state for markets that are constantly moving in price, while we should always be wary of it, it is the variable nature of markets that makes them investable in the first instance.
Nutmeg’s investment team monitor and model how market volatility might affect all our portfolios. We are always ready to make the adjustments we believe are necessary to protect portfolios and move them into positions of growth.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.
(1) The VIX index is using a basket of short term equity options to “imply” the level of volatility in the market. An option is a financial instrument that gives the owner the ability to buy something at a future date. Some equity options are listed on exchanges. Normally to calculate the price of an option, the level of volatility is an input parameter. The Vix index is based on the inverse concept. It uses the price of those listed option to “imply” the level of volatility needed to get this price. It gives a very dynamic and up to date view of market volatility expected by the different financial institutions active in the option market