Volatility has notably increased since the start of 2022, with equity markets being hit the hardest.
The S&P 500 Index has recently seen a 10% price pullback, something markets haven’t experienced in over 12 months. Global equity markets have also been negatively impacted.
Such levels of volatility may be concerning for investors who have benefitted from periods of relatively uninterrupted growth throughout 2021. However, when viewed in a longer-term, historical context, we can see that periods of volatility are: 1) temporary, 2) normal, and 3) potentially beneficial, especially for investors who stay invested or even increase their investments in risk assets during turbulent times.
Let’s take a closer look at the current period of volatility, and what previous episodes can teach us about where to go from here.
What’s behind the recent volatility?
Much of today’s volatility has been tied to the beginning of central bank interest-rate hiking cycles around the world. Central banks, such as the U.S. Federal Reserve and Bank of Canada, are looking to increase rates to prevent inflation from getting even higher, in addition achieving other important economic goals. For example, current market consensus suggests the U.S. Federal Reserve will end asset purchases in March and increase their benchmark rate four times this year. Closer to home, while the Bank of Canada this month decided to hold its rates steady, they have stated that conditions to start raising interest rates have been met and markets are currently pricing in as many as six hikes by year end.
Expectations of rate hikes, which make borrowing more expensive and can cool economic expansion, have led to investors reassessing how to price assets in a changing landscape. Consequently, this lack of certainty is causing considerable volatility, especially in stock markets. Furthermore, volatility could also be driven by market participants responding to pandemic-era economic conditions amid less accommodative monetary policy and lower levels of liquidity, an environment that we have not witnessed for more than two years.
We expect volatility to become increasingly common as we get closer to, and deeper into, rising-rate cycles.
How much should I be concerned?
Market volatility can be unsettling. However, the recent 10% equity market pullback in the S&P 500 Index can also be interpreted as a healthy sign. Occasional market corrections can serve useful purposes, such as checking stocks that may have risen far beyond their intrinsic value, and giving selective investors a chance to buy into stocks at more reasonable prices.
Corrections are not uncommon events either: historically, equity markets experience a 10% pullback, considered a healthy correction, in two out of every three years (source: Bloomberg). Moreover, historical data also illustrate that in the three months before and after the first Fed rate hike of a given rising-rates cycle, stocks tend to trade in a narrow 10% range. Consequently, it is typical over this six-month period to have a 10% pullback in stocks. However, investors who stand pat during and after such a period of volatility could benefit, as stocks on average have gained 7% in the six months following this first hike, and 12% in the 12 months after.
What are our best options?
While it might appear difficult during times of volatility, staying the course is often the best solution. We encourage investors to remain disciplined, as in our opinion, volatility is temporary. The long-term investment outlook shows that corporate earnings in the U.S. are expected to be in the high single digits this year. Companies with strong earnings and good balance sheets are poised to do well. Moreover, in advanced economies sustained consumer demand and still-favourable financing conditions are expected to underpin a strong recovery in investment. Against this backdrop, staying the course, despite short-term economic and market dislocations, could be key for investors. During these uncertain times, it is critical that investment advisors engage their clients to provide longer-term context to today’s market environment, to keep them invested and focused on their investment plan and financial goals.