Three Strategies to Prepare for Rising Volatility

We all knew volatility couldn’t stay low forever, even with solid global growth and low inflation. Rising volatility is common in the late stage of the economic cycle, and negative headlines have been dominating market sentiment. Given recent concerns about higher-than-expected inflation, more aggressive central bank action, rising US deficits and a “tariff tantrum,” the case for market uncertainty continues. I wouldn’t be surprised if volatility remained elevated for the rest of this year.

It’s not just the headlines. Data also supports the case for higher volatility. I analyzed the standard deviation of major asset class returns during economic expansions within the last 15 years. Compared to this historical average, current volatility is actually very low, particularly in the high yield, emerging market debt, and equity markets. While volatility in US equities has risen in the last year, it’s still more than 15% below the average volatility in expansionary periods. Central bank policy, inflation expectations, potential trade wars and historical data support volatility remaining elevated and likely moving higher.

Be prepared

During periods of higher volatility, it’s important to be prepared. Here are a few strategies to help investors navigate a higher-volatility environment:

• Understand correlations before you allocate

True diversification requires more than allocating broadly across asset classes. I believe understanding the relationships, or correlations, between asset classes over time is critical for protecting capital. When do correlations change? When do they remain stable? Identifying the patterns and when they happen can help investors maintain a truly diversified portfolio that can withstand higher volatility.

• Seek quality, sustainable income

I believe that balance sheet quality and a sustainable dividend growth policy are critical factors for understanding potential return and managing drawdown risk. As seen in the table below, companies with a stable or growing dividend policy have outperformed over time. It’s important to evaluate a company’s free cash flow and earnings growth. With volatility on the rise, identifying high-quality names with sustainable dividend growth can potentially provide downside protection.

• Recognize the macro sensitivities

Interpreting the macroeconomic landscape is an integral part of asset allocation. Asset classes can respond differently to macroeconomic factors. Analyze historical macroeconomic environments and assess which assets show sensitivity to a given macroeconomic factor. For example, how does higher inflation impact the equity market? How do dividend-paying equities tend to perform when rates are rising? In which part of the cycle does high yield typically experience the worst drawdown? Knowing how macroeconomic factors can affect different assets can help prepare a portfolio for potential drawdown.

Volatility can be challenging, but consistent returns are possible with a tactical approach. Analyze each asset class and seek opportunities in areas where you can be compensated for taking risk. Diversifying a portfolio’s return streams, understanding its income sources and its macro sensitivity can help to manage drawdown risk and protect capital as volatility rises. 

Past performance is no guarantee of future results.
Diversification does not ensure a profit or guarantee against a loss. 

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