Following the 2008 global financial crisis, central banks intervened in markets by reducing interest rates and ‘printing money’ through quantitative easing (QE). In theory, this increases liquidity in the financial sector to maintain stability and promote economic growth. Stabilizing the financial sector encouraged lending, to allow consumers to spend and businesses to invest.
This provided markets with reassurance that central banks would support them to ensure they were running smoothly. This led to markets rising for more than a decade with relatively low volatility; this was at a time when there was little inflation so banks could continue to provide support.
In 2018, the Federal Reserve (Fed), US central bank, announced it would be tapering QE. As a result the markets fell, causing volatility to spike. Many asset classes had some of the worst returns since the global financial crisis in 2008, as global liquidity tightened because of the withdrawal of QE and rising interest rates. Also, at that time there were other factors in play, such as rising geopolitical concerns including Brexit, US political gridlock, and the ongoing trade conflict between the US and China.
In the end, the Fed pivoted and reversed its policy to continue printing money and keeping an accommodative stance. This meant that risk assets continued to appreciate and market volatility dampened down again.
The next large spike in volatility was in 2020 due to the pandemic and the lockdowns that followed. Markets dropped significantly, but the central banks reacted quickly to support them. They reduced interest rates and increased the size of their balance sheets, pumping trillions into markets. Governments also provided fiscal stimulus to support people through this challenging time, which also helped to stabilise economies and markets. This again led to market volatility falling.
These key events suggest that volatility since 2008/9 has been muted due to loose central bank monetary policy and more recently fiscal stimulus. Going forward, however, this seems to be changing (at least for the time being).
Whilst the Fed and Bank of England are moving rates higher and looking to wind down their balance sheets to try to tame inflation, volatility has spiked and over the short to medium term it could remain elevated compared to levels we’ve seen in the past decade. Rising inflation, tighter monetary policy, slowing economic growth, Russia/Ukraine war (and other geopolitical events) and supply chain issues are all contributing to this volatility.
Mitigating against volatility
For pension schemes, risks against market volatility can be mitigated by holding a diversified portfolio of risk assets including equities, property infrastructure, commodities, or considering risk parity funds that adjust risk according to market conditions. However, at the moment most markets are tending to move in line with each other, so the benefit of diversification is more limited. Active management can also assist in being able to reduce volatility, as managers can take off-benchmark positions such as holding cash.
Trustees need to be mindful that they are long-term investors, and short-term fluctuations should not be of great concern. However, they should consider their long-term strategy and ensure they understand the risks they are running as well as having a covenant to support those risks. If this has been considered, then market volatility should not cause any significant changes to the strategy.
I encourage trustees to consider speaking to their investment consultant before making any changes to their investment strategy to ensure they are suitable.