Hamish Tadgell – Taking Stock of Recent Market Volatility
Hamish Tadgell, Head of Australian Equities and lead Portfolio Manager for SGH High Conviction Fund & SGH Ex-20 Australian Equities Fund
In the last week the S&P 500 plunged more than 5%, the NASDAQ 100 was down 7% and the Nikkei fell an astonishing 13% before triggering a circuit breaker and recovering 10%. Meanwhile, measures of equity market volatility like the VIX soared to their highest levels since the pandemic crisis of 2020. So, what is behind all these dramatic moves and what do we do now?
After the strong rally we have seen since last October, when equity markets bottomed, there has not been a pullback of more than 5% until the last week. History suggests it is not unusual to see corrections of this nature and consolidation in a bull market; it is arguably a necessary and healthy condition for markets to move higher.
The sustained period of low volatility has been remarkable and a central condition of market performance over the last 12 months.
The VIX market volatility index (sometimes referred to as the ‘fear index’), which investors widely use to anticipate future market volatility, has been trading in a band of between 11 and 21 and averaging 14.5 over the last year, until spiking to 39 last week.
In the post-pandemic recovery era, the market has settled into a low volatility environment that has been perpetuated by the idea of an economic ‘soft landing’, conditioned by co-ordinated fiscal and monetary policy, and the belief inflation pressures will ease, allowing central banks to cut rates and sustain growth.
That volatility has remained so low that it has been all the more surprising against the background and uncertainty of rising geopolitical tensions, trade protectionism, conflicts, and wars.
The intraday spike in the VIX Index on the 5th of August put paid to that. To put it in perspective, the volatility squeeze was the largest intraday VIX move ever: greater than what we saw during Covid, the GFC and the Long-Term Capital Management crisis, mirroring Black Monday 1987.
What triggered this has been the subject of much discussion. Extreme positioning, growing questions around the sustainability of spending and returns on AI, slowing economic data, rising tensions in the Middle East and the out-of-consensus move in monetary policy tightening by the Bank of Japan have all been raised.
Much has been made of the Japanese carry trade unwind as central to the recent correction. But it seems more symptomatic of the broader market psychology and attitude: a preparedness to take on more risk perpetuated by the low volatility, low-risk soft landing narrative.
The comfort around this low-volatility trade has been questioned.
Without a doubt, the price and market action marks a derisking event. Identifying the catalyst for change is not always obvious, but when markets become skewed and crowded, as they have, and the prevailing view changes, things can unwind quickly and violently.
When markets move forcibly, there is always the risk that a significant market participant will be caught short and forced to liquidate, causing broader systemic issues. This is not always obvious at first instance and remains a risk: riptides can take time for the bodies to float to the surface.
More broadly, it raises the question of whether this marks the beginning of a regime change and something more systematic or is just a healthy correction and consolidation along the path to markets continuing to broaden out with an increasing number of stocks contributing to the market’s performance.
At least at this point, it is our observation that this is a more technically driven event with traders seeking to cover, deleverage, rebalance, and manage risk. However, with the VIX still in the twenties, the market is priced for stress, and we arguably need to see a sustained period of calm and volatility return to lower levels for the broader market to become more constructive.
As fundamental investors, we look to take advantage of market volatility and exploit what we see as mispricing opportunities based on longer-term fundamentals.
As we enter the second half of the year, there is growing evidence that economic growth is starting to slow, but it’s premature to imply that the preconditions exist for a hard landing. Further, central banks appear increasingly alive to manage their dual mandates of targeting inflation and employment.
We have already seen the UK, European and Canadian central banks cut interest rates, and the prospects of rate cuts in the US and New Zealand now seem more than likely, potentially as soon as next month.
In Australia, it remains more uncertain and complex given the homegrown issues around robust public demand and government fiscal stimulus (driven by infrastructure construction spending, the growth in the NDIS-related workforce and the surge in immigration), which appear to be underpinning inflation and constraining the RBA’s ability to provide interest rate relief absent a sharper decline in economic conditions and higher unemployment.
After a rally where valuation and multiple expansions have been the main drivers of returns, the sustainability of earnings growth becomes the critical determinant of stock price performance at this stage of the market cycle. Our focus is on identifying and holding quality companies with sustainable earnings growth at an attractive margin of safety (through paying a sensible price).
Over the last year, we have held little to no exposure in the property sector, given concerns around rising rates and valuations, but with the prospects of interest rates potentially topping out and next move lower, we see better risk reward and value latency in property stocks and quality longer duration holdings with defensive earnings, like Chorus and healthcare (ResMed and CSL). We have been using recent price volatility to selectively add to Australian REITs and the New Zealand retirement sector, which we see as an attractive way to play the property recovery.
Domestic reporting season over the next few weeks will be important in providing a read on business confidence and the economic pulse and in providing a window into company earnings trends. This will no doubt help further shape our views, and we look forward to sharing the post results.
Disclaimer: SG Hiscock & Company has prepared this article for general information purposes only. It does not contain investment recommendations nor provide investment advice. Neither SG Hiscock & Company nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in the Funds. Past performance is not necessarily indicative of future performance. Professional investment advice can help you determine your tolerance to risk as well as your need to attain a particular return on your investment. We strongly encourage you to obtain detailed professional advice and to read the relevant Product Disclosure Statement and Target Market Determination, if appropriate, in full before making an investment decision.
SG Hiscock & Company publishes information on this platform that to the best of its knowledge is current at the time and is not liable for any direct or indirect losses attributable to omissions for the website, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions.
