COVER STORY

We could get used to this.

Like kayaking down a tranquil stream while taking in beautiful sights along the way, the recent absence of whitewater conditions in U.S. financial markets might have some investors feeling a bit too comfortable.

Though especially welcome after the tumult of the financial crisis, the lack of turbulence since at least mid-2012 is not the norm. And according to Northern Trust Executive Vice President and Chief Investment Strategist Jim McDonald, the relaxed row atop placid waters isn’t likely to last, either.

Metaphorically speaking, that is.

“We’ve enjoyed an unusually long stretch without a correction,” McDonald said, referring to a 10% drop in stock prices. “But corrections are a normal part of a bull market cycle, and there’s no reason to think that’s changed.”

What little downside volatility there’s been since the current bull market began in March 2009 usually has been associated with political dysfunction in Washington. But the recent budget accord took rancorous arguments over the debt ceiling and the possibility of a default on government debt off the table until at least next year. An easing of the eurozone debt drama has helped to smooth out the ride as well.

Changing tide?

Investors have taken notice of the political ceasefire on both sides of the Atlantic.

Through early February, the U.S. stock market had gone more than 140 days without even a 5% decline, close to three-times the normal length.1 That extended stretch of market tranquility finally ended shortly thereafter, but equity prices quickly rebounded without ever dropping into “correction” territory.

With volatility down and prices up — the S&P 500 Index has gained about 210% (including reinvestment of dividends) since March 20092 — McDonald worries that investors have become complacent.

Not that he sees a storm brewing, either. Still …

“It’s important to be realistic about what usually happens within an economic cycle,” McDonald said. “Prices don’t go straight up. There’s an ebb and flow.”

Helping hand — for now

Besides an economic recovery — albeit a modest one — a major reason for the lack of volatility in recent years has been an unusually benevolent Federal Reserve (Fed). The time-honored maxim, “Don’t fight the Fed,” has rarely been more relevant, with policymakers taking extraordinary steps to support a struggling economy.

Among those unconventional measures have been three rounds of quantitative easing, or QE, in which the Fed purchases Treasury and mortgage debt to hold down long-term borrowing costs.

Still, markets wobbled in May 2013 after then-Fed Chairman Ben Bernanke surprised investors by suggesting the Fed was prepared to begin pulling back (“tapering”) on QE by the end of the year.

Though Bernanke followed through on his plans — he announced the first reduction in December — he and his successor Janet Yellen learned a vital lesson.

“Policymakers have to be crystal clear about what they’re doing and why they’re doing it,” said Northern Trust chief economist Carl Tannenbaum. “It’s important that markets not only hear what the Fed says, but understand what it means.”

Hear me now?

Stock and bond markets finally settled down last summer after Bernanke and other officials repeatedly emphasized that a gradual Fed egress from the bond market did not represent the much-feared “tightening” of monetary policy.

Barring a substantial downgrade to the U.S. economic outlook, Tannenbaum sees little chance the Fed will deviate from its plan to reduce and finally end its purchases in the Treasury and mortgage-backed securities markets by next fall. And although economic growth in the U.S. decelerated during the winter, Tannenbaum is confident most of the slowdown was caused by brutal weather.

“By itself, the end of the third round of QE, known as QE3, should not necessarily induce market volatility,” Tannenbaum said. “The Fed has clearly communicated what will happen to its bond-buying program, and the odds of a negative surprise there appear very small.”

Besides, he noted, there are plenty of reserves available in the banking system for lending, assuming consumers and businesses want to borrow.

Potentially more problematic is when and under what circumstances the Fed will begin to hike short-term interest rates, the traditional policy lever by which the central bank tries to influence inflation and growth.

Short-term interest rates were cut to virtually zero in December 2008, where they’ve remained ever since. To spur an economic recovery and dampen market volatility, the Fed — chastened by the market’s “taper tantrum” last spring — has taken the unusual step of explicitly warning about upcoming changes to traditional monetary policy via communications known as “forward guidance.”

Although investors appear to have accepted the Fed’s argument that ending QE3 does not represent a tightening of monetary policy, higher benchmark interest rates could be another matter entirely.

Moving the goal posts

Throughout the last half of 2013, the Fed issued repeated assurances that it would not consider raising short-term interest rates until unemployment fell to 6.5%.

Though consumer prices have remained subdued, unemployment declined faster than expected, reaching 6.6% in January. Ironically, that relatively good news triggered concerns about a tightening cycle, this time centered on short-term rates.

Tannenbaum thinks the issue of guiding investor expectations will be crucial to containing market volatility.

In perhaps an unintended reprise of Bernanke’s ambiguous hints last year about tapering, one of Yellen’s early attempts at providing forward guidance did not go smoothly. In March, she seemed to suggest the first rate hike could come next spring, about six months earlier than investors had expected.3

Or maybe not.

In any event, the Fed has dropped the linkage between unemployment and interest rates in favor of a more qualitative assessment of the labor market. Tannenbaum approves, given his view that the shrinking jobless rate is more reflective of people leaving the labor market than of a strong pickup in employment.

Bubble trouble

China represents another potential source of volatility. Although that country’s economic growth still dwarfs that of the developed world, China’s central bank has been trying to control explosive credit growth with mixed results.

“The availability of cheap credit created a property price excess and inflated the value of many private, wealth management products,” Tannenbaum said. “The new regime in Beijing would like to impose credit restrictions, but it is hard to take just a little air out of an asset price bubble.”

He describes the process of wringing excess leverage from China’s official and so-called “shadow” banking systems as “delicate.”

Negative feedback

Tannenbaum is also keeping an eye on emerging markets and suggests the Fed do so as well.

In recent years, those super-low U.S. interest rates sent increasing amounts of money overseas in search of more enticing yields. But with the Fed normalizing monetary policy, capital flows have reversed, causing sharp drops in certain emerging market currencies.

Nonetheless, Tannenbaum expects the Fed to stay the course, barring a negative feedback loop developing in one or more developing economies.

“If there were a major setback in a large emerging market, I doubt the U.S. would be immune to it,” he warned.

Reality bites

Assuming market volatility returns to normal levels, how might portfolios be structured to potentially minimize the impact?

Barring a clear change from current economic or market fundamentals, McDonald believes it’s a mistake to react to heightened volatility.

Instead, McDonald advised investors focus on how their money is allocated between the various asset classes.

“That’s the key factor,” he said. “Creating a stable asset allocation ratio that fits an individual’s risk tolerance is the most important decision an investor can make.”

Sensitivity training

Though all investments carry a degree of resale price risk, McDonald said one way to potentially reduce a portfolio’s volatility is to increase its allocation to short- to intermediate-maturity government bonds. Some investors worry that fixed-income assets could suffer as the Fed raises interest rates, that hasn’t always been the case.

For example, interest rates were rising during the severe equity bear market in 1973–’744, but intermediate-term government bonds returned 5.1% over the two years.5 Similarly, medium-term government bonds gained 18.9% in 1981–’82,6 also a time of sky-high interest rates and tumbling stock prices. And as benchmark interest rates were raised from 3% to 19% between 1963 and 1981,7 intermediate-term government bonds experienced only one down year (-0.74% in 1969)8 while generating a compound annual return of 5.2%.9

“The short- to mid-point of the Treasury yield curve provides good liquidity and a significant degree of stability for a diversified portfolio,” said McDonald.

Scaling back

A second way to reduce a portfolio’s sensitivity to market gyrations is to shift into lower volatility investments within the risk category itself.

For example, investors might cut exposure to such volatile asset classes as emerging markets, natural resources and commodities, and move instead into high yield bonds. According to McDonald, global infrastructure stocks tend to be less volatile than emerging market equities as well.

McDonald said professional portfolio managers also can overweight companies that historically have shown below-average volatility and above-average quality, as measured by financial metrics and managerial competence.

Getting there

Recent experience notwithstanding, volatility goes hand-in-hand with investing in assets that have significant upside potential.

And with the Fed seemingly intent on restoring monetary normalcy, the lack of a real or perceived central bank “backstop” for asset prices could make those fluctuations more pronounced. Seven years after the first tremors of the financial crisis shook capital markets; the monetary crutch is being removed.

So, as investors paddle into the more turbulent financial waters that probably lie ahead, they should take appropriate measures to desensitize their portfolios to risk. They should not, however, necessarily fear plunging over some rocky edge.

“If you’ve been a long-term investor,” said McDonald, “normal market conditions usually have been good enough.”

Even if you got a little wet along the way.

Past performance is no guarantee of future results.

Neither diversification nor an asset allocation strategy guarantee a profit or protect against a loss.


Investing involves risk including the possible loss of principal. For risks specific to each fund please refer to the fund prospectus.

S&P 500® Index is an unmanaged index consisting of 500 stocks and is a widely recognized common measure of the performance of the overall U.S. stock market.

It is not possible to invest directly in an index.

1“Gut Check.” Investment Strategy Commentary. Northern Trust. February 6, 2014.
2 “US equity bulls are banking on growth.” Michael Mackenzie. Financial Times. March 13, 2014.
3 “US and Europe stocks show resilience after sharp Asia fall.” Dave Shellock. Financial Times.       March 21, 2014
4 Federal Reserve

5 “Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–1987). Roger G. Ibbotson and
    Rex A. Sinquefield. The Research Foundation of the Institute of Chartered Financial Analysts.
    Page 179.
6“Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–1987). Roger G. Ibbotson and
    Rex A. Sinquefield. The Research Foundation of the Institute of Chartered Financial Analysts.
    Page 179.
7 Federal Reserve
8“Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–1987). Roger G. Ibbotson and
    Rex A. Sinquefield. The Research Foundation of the Institute of Chartered Financial Analysts.
    Page 59.
9“Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–1987). Roger G. Ibbotson and
    Rex A. Sinquefield. The Research Foundation of the Institute of Chartered Financial Analysts.
    Page 178.

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