Morgan Stanley
  • Wealth Management
  • Feb 8, 2021

Understanding the Volatility Playbook for the New Economic Cycle

The increase in market swings over the past year is typical of business-cycle transitions, and investors can learn to find opportunities along the way.

You may be getting a little tired of wild stock market swings by now. Market volatility has been elevated for nearly a year. The VIX, popularly known as the “fear index,” measures the implied daily volatility of stocks that comprise the S&P 500. It has remained above 20—vs. the average of 14 over the prior decade—since the third week of last February, when the spread of the novel coronavirus began to rattle global investors.

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Given such persistently elevated volatility even after the market’s recovery from last spring’s selloff, some investors wonder if it signals a structural change in markets, perhaps brought on by social and political turmoil, or the surge in popularity of online trading.

I don’t believe that is the case. In fact, the current extended chapter of volatility, although not commonplace, is a hallmark of the standard recession playbook. The past four recessions have featured similar periods of market churn at this stage. Indeed, during the most recent two recessions—2001 and 2009—the VIX traded above 20 for even longer than we’ve experienced so far. 

This makes intuitive sense. Recessions, by definition, usher in new business cycles, and that transition inevitably leads to sector and asset class rotation, which leads to volatility. 

What’s Different This Year

Whipsaws between optimism about the recovery and fears of disappointment may seem even more pointed than usual this year because this recovery depends on a novel factor: vaccine rollout. Given concerns about vaccine distribution and the efficacy against new variants of COVID-19, we doubt that volatility will meaningfully recede before May or June, when the durability of full economic re-opening may feel more certain.

Outsized and unprecedented monetary stimulus from the Federal Reserve has heightened market volatility—but predictably so. The Fed’s stimulus has already expanded its balance sheet by more than $3.5 trillion to nearly $8 trillion, a number that continues to grow at a rate of $120 billion a month. In turn, this largesse of liquidity, on top of extremely low interest rates, may encourage some investors to extend leverage and margin debt, which turbocharges daily volatility.

Another indication of more volatility ahead: Fed Chair Jerome Powell’s most recent commentary made clear that the central bank is more focused on supporting the economy and fighting unemployment than on restraining market bubbles, making it less likely that the Fed would act to suppress market volatility the way it has in the past. 

Seeking Opportunities

So how should investors navigate this period of volatility? First off, we should note that major risk indicators are not flashing. The yield curve has steepened to its widest level since the summer of 2017, a sign that investors see economic expansion ahead. Plus, procyclical sectors and asset classes, such as emerging markets and small-capitalization stocks, have shown resilience.

In fact, we believe the current volatility may have created more opportunities for investors, who may want to consider active stock picking while focusing on positive fundamentals. The U.S. labor market, while still weak, is stabilizing; car sales are rebounding; home sales are surging, and the manufacturing recovery and inflation markers are picking up. Quality franchises with strong valuation support and cyclical leverage in sectors like financials, industrials, consumer discretionary and energy should outperform. New market leadership is likely to come from trends around the digitization of service businesses, higher infrastructure-related spending and the housing boom.

Stick with what history has taught us. The business cycle is alive and well and likely to produce new winners that don’t already dominate the indexes.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Feb 8, 2020, “Volatility Right on Schedule.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

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