A paradigm shift in financial markets has taken place since 2008, into a more volatile investment environment. This shift will demand different ways of managing risk. Let’s take a look at the forces behind the evolution to this new paradigm and examine how investors might navigate this more volatile investment climate.

When examining our past, many economists look for parallels on which to base their future assumptions. The question that many economists are asking today is, Will the next decade resemble the 1930s-40s or the 1980s-2000s? Conditions today are different than in either period. In the 30s and 40s, a combination of high corporate leverage and high government leverage was a poisonous backdrop that caused more frequent recessions and periods of market instability. At least today, we have more sustainable corporate balance sheets. The problem is, we still have higher-than-desired consumer debt loads. Developed-world government debt balances are also unsustainably high. Thus, as we are now in a deleveraging phase, it is not too much of a stretch to imagine that the next decade will look more like the early part of the last century, rather than the latter part.

Lower Volatility Sows the Seeds of Higher Volatility

It is ironic, but I believe that today’s higher investment volatility is the consequence of attempts by central banks to engineer a less volatile economic environment. This environment, one in which recessions are shorter and expansions longer, has its roots in the early 1980s and has spanned over two decades. Dubbed “the Great Moderation,” the period commenced with the resetting of inflation expectations by Fed Chairman Volker. This psychological watershed was backstopped by the globalization trend which helped defuse inflationary influences (as overseas capacity robbed firms of pricing power, acting as a “relief valve” for domestic price pressures). The decline in inflation and inflation volatility helped support a prolonged decline in interest rates.

Lower Perceived Riskiness and the “Paradox of Credibility”

Improved corporate balance sheets, more transparent monetary policy, and new “risk diversifying” financial instruments also lowered the perceived riskiness of investing in securities tied to economic growth. Unfortunately, the stable macroeconomic environment and strong central bank credibility created a false sense of security. The Great Moderation era led to excessive credit expansion and an underpricing of risk. Valuation bubbles and excess debt were the consequence, manifesting three times since the early 1990s in both the U.S. equity and two real-estate busts.

To combat the economic aftereffects of burst bubbles, the Federal Reserve (“Fed”) aggressively reduced interest rates. But because of increasing systematic leverage, rates had to be lowered further in each cycle, kept lower for longer, and raised less each time before the economy tipped back into recession. The story in Europe and Japan is similar. Today, we are effectively at the zero interest rate boundary, and here we have remained for almost four years. At this point, the only policies left to the Fed, the European Central Bank (ECB) and the Bank of Japan (BOJ) are unconventional, and it is unclear whether they will have much of an effect on their respective economies. Indeed, HSBC recently investigated the effectiveness of each of the quantitative easing programs initiated by the Fed and concluded that the programs were exhibiting signs of diminishing returns. If central banks in the developed world are becoming less effective stewards of the business, interest rate and credit cycles, it seems likely we could experience more frequent economic volatility; more “soft patches,” shorter and less robust expansions and prolonged recessions.

A Nasty Side Effect of Volatility – Higher Correlation

It is not just commodities that have been experiencing increased correlation with equities. Almost all financial markets are now more highly correlated to each other. There are a number of macro contributors to the volatility and correlation phenomenon. However, reinforcing the macro backdrop is the continuing evolution of the market structure – namely, the rise of the ETF phenomenon.

Continued “Fertilizer” for Higher Volatility

The landscape remains rife with potential volatility. Several of the more obvious factors:

• Fiscal cliff – Political infighting in the U.S. Congress raises the risk of fiscal policy paralysis, and the so-called fiscal cliff still looms, merely delayed. The IMF estimates the expiration of U.S. tax provisions and automatic spending cuts mandated by sequestration could result in a 4% hit to GDP.

• Europe – ECB President Mario Draghi has verbally promised to “save the Euro” and has hinted that he will keep funding European sovereigns via the short end of the curve but investors have yet to see a clear indication of how he will accomplish this. And in the meantime, the European economic environment continues to deteriorate.

• Mideast Tensions – The “Arab Spring” continues to roil the Mideast political landscape. And in the background, growing concerns about Iran’s nuclear capability and the possibility of an armed response by Israel will keep tensions high and will affect the price of oil – which has the potential for significant negative consequences to global GDP.

• Uncertain Chinese Growth – The rebound from China after the GFC was stunning, but was predicated on an unsustainable level of stimulus. The Chinese then suffered the aftereffects, including a higher-than-comfortable level of inflation and burgeoning bad debts from mal-investment. Today, their economy is suffering a lack of demand from Europe, pressuring their export engine. But a response like 2008-2009 is not likely. So China, rather than a source of economic growth may, on the margin, be a source of economic drag.

To Those Whose Investment Time Horizons are Shrinking Quickly, Volatility is Dangerous

Why should we worry about volatility – why not just ride it out? Or wait it out? The “wait it out” option is straightforward and it is one many people have chosen to adopt out of fear. But it means that investors need to resign themselves to hiding out in cash and other low-return investment options. On top of mediocre returns, investors might be setting themselves up for a truly awful experience if the seemingly low-risk investment turns out to be anything but.

The “ride it out” option is the “buy it and put it away in the drawer” approach. At South Coast, we continue to advocate that a long-term approach is the best way to invest because among other things it tends to diminish “entry point risk” (basically buying before a correction, then selling before it has had time to recover). With a long time horizon, the risk that a volatile market hurts you either on the entry point or the exit point diminishes.

Unfortunately, volatility is pernicious for those whose time horizons are shrinking. And this is the central issue for a growing segment of the population currently in or approaching retirement. This “baby-boom bulge” is forcing a shrinking of time horizons. Ironically, this is occurring at the same time that the markets are becoming more antithetical to investors with shorter time horizons. And these investors are demanding that income become a much larger, more central part of their total return.

Having Your Cake and Eating It Too…

The Utopia of investment management is to produce high returns with no volatility or downside risk. Unfortunately this Utopian ideal is just that – an ideal. But it does frame our goals – it is our “stretch goal.” We believe that we can continue to be investors with long-term time horizons, while at the same time managing risk through active portfolio management. We also recognize that investors are increasingly uneasy with the volatility that is a reality of today’s market. Thus, we create flexible, multi-asset strategies that can, at their core, be as long-term as possible while managing the often treacherous volatility of the current and likely protracted investment environment. Volatility is not going away any time soon, but acknowledging this volatility and setting realistic expectations can help investors deal with it.

– Written by Jeff Fisher, Partner with South Coast Investment Advisors, LLC