THE MARKET VOLATILITY CONUNDRUM 

With the significant uptick in worldwide Covid-19 cases, there has been a parallel increase in equity market volatility. US equity markets, as measured by the S&P 500, have now experienced a “correction”, or a drop of 10%. In this note, The Mather Group would like to share its perspectives on some of the factors driving this volatility, identify our risk management tools in use to limit portfolio erosion and demonstrate that markets have responded quickly—and often quite positively—to past corrections and pandemics.

Everyone is concerned with the growing human toll resulting from this virus, but markets are looking beyond this unfortunate level of human tragedy. More specifically, markets are seeking to dimension its potential economic and financial impact. However, the level of uncertainty at this stage of the virus is simply driving higher levels of market volatility instead.

For example, China is the world’s largest annual exporter at $2.2 trillion. 18% of its exports go to the US, with many of its shipments forming an integral part of US supply chains. Apple is a pioneer of supply chain management, having created the concept of US-based chip design, Korean chip fabrication and Chinese final assembly of its iPhones. Foxconn, Apple’s primary manufacturer in China, has 29 plants employing 350,000 people producing 50,000 iPhones daily, or half of Apple’s entire production. 200 of Apple’s parts suppliers, or 48%, are also China-based.

With $260 billion of revenue, Apple is now a case study of market uncertainty. 20% of iPhone 2019 sales occurred in China, but, like many companies, it now faces significant supply and demand issues. Workers in its plants and retail stores are absent in large numbers due to mandatory travel restrictions, illness, the care of family members and the fear of infection. Increasingly, these absences are unpaid, leading to a fall in both personal income and consumer spending throughout China.

With its loss of production, exports and consumer expenditures, China’s Q1 GDP Q1 is forecast to fall near 0%, well below its annual target of 6%. The Chinese government has started several fiscal and monetary initiatives to offset this downturn, but its export earnings will be insufficient to fund them. And, fewer exports to the US mean fewer Dollars to recycle back into Treasury bonds, with China now holding $1.1 trillion of US bonds, or 16% of the total. As a further uncertainty to this virus crisis, some bond analysts are concerned that the cost of US borrowing could rise if China’s appetite for Treasuries diminishes. Aware of these shocks, the market is now pricing in further rate cuts from the Fed to occur in 2020, which—good news—could have salutary effects for mortgage pricing and housing market sales.

In the face of such uncertainty, The Mather Group utilizes—and has utilized for many years—several active risk management tools. With respect to fluctuating interest rates, for example, duration management is key in that the goal of seeking higher yields must be made in parallel to the goal of reducing the potential loss of principal if interest rates suddenly change. As a result of this strategy, our bond portfolios now have slightly less duration risk than our portfolio benchmarks.

In the equity markets, the recent, almost manic, focus on just a handful of technology stocks appears to have many similarities to the so-called “tech wreck” of 2000. In contrast, The Mather Group seeks to construct portfolios with a balanced approach using each of the 11 individual S&P sectors—not just technology. As shown below, sector performance does not move in lockstep, with Real Estate and Utilities, for example, having 1/3rd the performance downturn experienced by the Energy Sector, and even outperforming the S&P 500 Index during the last month and year-to-date.

Just as The Mather Group seeks to use sector diversification as a risk management tool, it also seeks to diversify portfolios across numerous market cap and geographic asset classes. More specifically, the technology stocks mentioned above were entirely in the US Large Cap Growth segment. This ignores the fact that US markets are only 53% of the value of total world markets. Hence, The Mather Group constructs your portfolios on a global, not domestic only, basis. And, portfolios include not just Large Cap equities, but Mid and Small Cap as well, again seeking broader diversification.

Another risk management tool used by The Mather Group is the rebalancing of portfolios when one sector or asset class moves outside levels established for it. These levels, of course, are drawn from the information, analyses and insights used to construct your personal financial plan. To The Mather Group, your plan is a living document that changes when your goals or requirements change, of course, but otherwise is the roadmap for your portfolio’s continued oversight. Finally, if markets do become volatile, The Mather Group seeks to identify any tax-loss harvesting opportunities which could help to reduce your overall tax burden.

Could this “correction” descend into a bear market? The Mather Group offers two sets of historic data which might help to respond to this question. First, there have been 22 corrections since 1974, or during the last 46 years. Only 4 of them continued onward into bear territory. But, let’s look at the outcomes from prior pandemics, as shown below. The graphic lists 13 separate pandemics which have occurred since 1970, including SARS, Ebola and Avian Flu. As these each have been global pandemics, their effect on markets is shown using the MSCI World Market Index.

More specifically, had investors followed their financial plan and stayed in the market during each of these pandemics, their average market return just one month later would have been 0.44%. Three months later, their average market return would have been 3.08%, and six months later their average market return would have been 8.50%. Note that at the end of those six months, the returns varied from -4.3% to 39.96%, suggesting that adherence to one’s financial plan during periods of increased market volatility was often rewarded.

All of us at The Mather Group share your concerns about the many unknowns associated with this virus, as well as the market volatility arising from it. We hope this note helps in some way to add fact to the discussion, and that you will contact us if you have further questions or other issues which you wish to share with us.

The opinions expressed, and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on The Mather Group's research and professional experience and are expressed as of the publishing date of this communication. The Mather Group makes no warranty or representation, express or implied, nor does The Mather Group accept any liability, with respect to the information and data set forth herein. The Mather Group specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice nor is it intended to provide comprehensive tax advice or financial planning with respect to every aspect of a client's financial situation. Past performance is not indicative of future results.

Sources: Fidelity, Charles Schwab, Wall Street Journal, World Health Organization, World Bank, International Monetary Fund, Bloomberg, Reuters