It’s the benign sort of volatility

Genevieve Signoret

Letter from the President

Market volatility, like the common cold, comes in more than one strand: the kind that knocks you flat and the kind that brings on only sniffles. We see the type of market volatility we’re experiencing today—called risk off—as benign. Risk off episodes, within one group of asset classes called risk assets, temporarily drive valuations down. But in another group, called safe havens, this type of volatility drives valuations up. Hence, through asset class diversification, we can and do build portfolios for our clients that limit losses from this type of volatility.

In the week to Wednesday 6 August, volatility as measured by VIX rose by 19%. Risk asset valuations fell: the S&P 500 Index by 2.6% and the Mexican peso against the dollar by 0.6% to $1.00=MXN13.24.

Obviously this impacted our clients’ portfolios. In our central scenario view, the bull market has at least two more years to go, so we have strongly tilted client portfolios in the direction of risk assets. But, because this is the benign sort of volatility, in two ways we have been able to limit our clients’ portfolio losses:

  1. We’ve made sure that their risk asset holdings were widely diversified. Our equity holdings are spread between developed markets (way down) and emerging markets (doing far better), across regions (Pacific stocks are holding up much better in this bout than European or American stocks), across countries and currencies (Mexico’s peso fell but its stock market was up in the week to Wednesday), and across sectors (if indeed the volatility driver is geopolitics, as many analysts theorize, then the oil producer stocks our clients hold could end up benefiting from today’s turmoil). And our clients hold more risk asset classes than equity alone. These include real estate (U.S. real estate fell by less than the S&P in the week to Wednesday) and U.S. junk bonds (ditto).
  2. We’ve made sure that our clients held not just risk assets but plenty of safe-haven assets too. (Note that in doing so we hedge against our own central scenario outlook. Am I making it clearer to you now why we take a multi-scenario approach to forecasting?) These include U.S. Treasury and other developed market sovereign bonds, huge exposure to the U.S. dollar, and some exposure to the Japanese yen, the Swiss franc, and Scandinavian currencies.

Now, as we mentioned at the start, not all volatility is alike. And, under our central-scenario view, once the Fed makes up its mind to raise rates and signals its intentions clearly to the market, a more dangerous strand of volatility will hit markets—one that drives valuations down even in many traditional safe-haven asset classes such as long-term developed-market investment-grade bonds.

We have protections built in against this more dangerous strand also. Our clients’ portfolios are overwhelmingly weighted toward safe haven currencies. This will provide some downside protection. But the main defense we provide to clients is careful financial planning.

For individuals, we build a detailed financial plan through age 100 and formulate a separate investment portfolio for every objective in the plan. Each portfolio has its own mandate that includes an investment horizon. This shields to the extent possible client liquidity requirements at every stage of life—their quality of life—from market fluctuations.

For organizations, among other services, we model treasuries and trusts to identify minimal, maximum, and optimal liquidity balances. Thus we identify what is truly excess liquidity. We can seek yield on this excess while—again through diversification but also by matching maturities on debt instruments to our expert cash flow projections—keeping the non-excess portion shielded from both benign and more virulent strands of volatility.


Previous Letters from the President

Low for Long, Loans to Kids (2014 08 01)

A worrisome buzz (2014 07 24)

Did you see that? (2014 07 18)

Do you click? Are you braced? (2014 07 11)

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