Economic Note: Higher volatility is likely to remain
Over the past few weeks, we have seen market volatility rise noticeably, and last week both stock market and bond market volatility advanced to two-month highs. Although most of the recent economic data has been pointing to marginal improvements in the global economy, it seems investors are focused more on the risks and on uncertainty. In our view, there are currently three main drivers to volatility: uncertainty surrounding the path of economic growth, uncertainty over Federal Reserve policy and concern over growing geopolitical instability in the Middle East.
Unclear Paths for the Economy and Fed Policy
While economic data continues to be mixed, we have been seeing signs that both the US and global economy are stabilizing. In the United States, manufacturing data in particular has been stronger. Two key measures-the ISM Manufacturing and ISM Services indices-both posted sharp improvements in August. Outside of the United States, data from most regions (with the exception of a few emerging markets, notably India) also shows that the global economy is continuing to heal.
However, one key area remains troubled: the jobs market. Last Friday’s labor market report for August was disappointing, with the data showing that 169,000 new jobs were created, less than the forecasted 180,000. The pace of jobs growth for July was also revised downward. Year to date, an average of 180,000 new jobs per month have been added, which is actually slightly less than the pace seen in 2012.
The mixed nature of the economic data itself adds to the sense of investor uncertainty, but it also contributes to the confusion surrounding the big question on everyone’s mind: What is the Fed likely to do? There has been widespread speculation that the central bank will soon begin to scale back on its asset-purchase program (a process known as “tapering”), but given the uneven nature of the economic recovery exactly when this will happen and to what degree remains unclear. Adding to the uncertainty, it is still unclear who is going to head the Fed in 2014 after current Federal Reserve Chairman Ben Bernanke’s term expires.
Rising Tension in the Middle East Unnerves Investors
Outside of the economy and questions about the Fed, growing geopolitical uncertainty in the Middle East has also contributed to market volatility. At this point, it is unclear how the humanitarian disaster in Syria will unfold, but it is clear that the problems in Syria and Egypt are emblematic of a broader issue: growing unrest in much of the Middle East.
From a financial markets perspective, one result of the unrest has been a significant reduction in oil supplies and exports. This has had the predictable effect of pushing up oil prices, which are now 25% above their April lows. Should the region’s violence escalate and the instability spread, higher energy prices would likely impede the global recovery.
Looking for Volatility Hedges? Consider International Stocks and Energy Companies
In the near term, we expect that volatility will remain elevated and that investors will remain anxious. Recent fund flows have confirmed this view, with flows out of equity funds spiking in recent weeks as investors have been seeking safe havens.
So where can investors look to find opportunities and to insulate their portfolios from volatility? One idea we have been advocating for some time is to seek out adequate levels of international diversification. Compared to US stocks, international stocks have cheaper valuations (partially because some risks are already priced in), and international stocks have seen some better performance in recent months. In addition, we would suggest adopting overweight positions to the energy sector. Earnings trends appear attractive for this area of the market, and energy companies can potentially act as a hedge against Middle-East induced market volatility.
Russ Koesterich is BlackRock’s Chief Investment Strategist