Volatility, like the long-term winter in Game of Thrones, is coming.
It won't be as bad as the Long Night that covered Westeros with a terrible darkness for generations. However, the current market rally likely will be upended by episodic, Red Wedding-like volatility.
We are later into the economic cycle and the calendar continues to be chock-full of potential macroeconomic and geopolitical flash points. The Federal Reserve going "full dove" by adopting a patient stance did spur a relief rally, but the forces that led to the sizable drawdowns in the fourth quarter of 2018 still exist.
Here are four reasons why an increase in volatility may be on the horizon, even as 2019's double-digit gains across the globe convey tranquility.
1. Slowing global growth. Global risk assets are unlikely to receive a boost from strong upward-trending global growth. Global GDP growth estimates for 2019 have trended lower since March of 2018, falling from 3.7% to 3.4%.
With surging growth unable to support consistent risk taking, the probability of volatility events could increase. If data continue to disappoint, as they have over the past year, with the Citi Global Economic Surprise Index (a measure of data surprises relative to market expectations) turning and staying vastly negative over the last nine months, global GDP results could even be lower than where forecasts stand now. In that case, volatility would likely ensue.
2. No consensus on how low growth will go. While economists agree that growth will decline, there is a wide band between the highest and lowest U.S. GDP forecasts for the next few quarters. The difference between estimates for GDP growth in Q1 of 2019 is 1.6 percentage points, with a high of 3.3% and a low of 1.7%. For Q4 2019, the difference widens to 3.4 percentage points, with the low estimate sitting at a -0.1%. In fact, the estimates for Q1 2020 are even wider, at 3.6 percentage points, and the low estimate is once again negative. This significant dispersion represents great current economic uncertainty that does not bode well for continued market tranquility.
3. Margins at cycle highs. From a corporate profitability perspective, profit margins are at cycle highs and starting to roll over as the effects of the U.S. tax cuts fade and slowing economic activity impacts manufacturing firms. We have also witnessed a decline in earnings growth estimates for some of the same reasons, with Q1 2019 earnings-per-share growth now expected to be negative.
This lower growth, however, is now being met with higher-than-average valuations. After the recent rally, US equity valuations have re-rated and now sit above their long-term medians. Looking ahead, lower margins reinforce the late-cycle, slowing growth narrative, and current fundamentals may not be able to act as a backstop if volatility spikes, given their recent trends.
4. High and increasing political risk. Greater global economic inequality and slowing growth trajectories have fueled populist politics across the globe. After an extended economic cycle with uneven beneficiaries of unconventional monetary policies, newly elected populist leaders are trying to engineer an economic soft landing.
Yet while fiscal policy can shift domestic consumption and wealth, it can also generate volatility through supply chain risks or new costs as well as increased government deficits. This has elevated risk in the political landscape, as measured by the sizable rise in the GeoQuant Political Risk scores that draw on hundreds of structural measures of country risk.
The political risk scores for nations such as the U.S., the UK, Italy, France and Germany have all increased by double-digit percentages this year alone. Higher political risk regimes can create episodic volatility that impacts headline sentiment.
Preparing for winter
If volatility is expected to overcome The Wall like the Night King, investors may want to ensure a level of portfolio ballast as we get deeper into 2019. This includes defensive bond strategies with lower volatility that generate income similar to broad aggregate exposures and defensive equities that trade at inexpensive valuations but have quality balance sheets.
Additionally, liquidity tools that allow investors to tactically adjust portfolios with speed, size, precision and efficiency will be important — like having a dragon ready to fight your battles.
Matt Bartolini is head of SPDR Americas research at State Street Corp.