COVID-19 and market volatility: How investors can potentially navigate risk

The coronavirus pandemic has created intense volatility in financial markets. Equity indices have swung from record highs in February on early hopes that the health crisis may have peaked, before plunging in March on increased fears of a global COVID-19-driven recession.

The spread of the virus - moving from epidemic to pandemic - and measures taken by policymakers to prop up their economies drove sometimes dramatic swings in equity prices. In addition, perceived safe-havens such as gold, long-dated bonds and the US dollar generally performed well.

Up until 2020, volatility had been relatively dormant for some time with many indices ratcheting up new peaks. The trajectory of AXA IM’s proprietary turbulence index, which tracks the evolution of parameters based on volatility and correlation, illustrates this pattern vividly. The index stood at 13.5 on 3 January but on 20 March jumped to 149 - a level not reached since the height of the 2008 financial crisis[1].

While the level of volatility has reduced somewhat since then, it remains at relatively elevated levels, sitting at 46.7 on 17 April.

The next stage

While some countries are seeing the number of confirmed coronavirus cases – and related deaths – continuing to rise, others are experiencing a flattening of the curve and starting to discuss lifting lockdowns and quarantine restrictions. However, the longer-term implications and economic impact remain to be fully seen.

Global growth forecasts have been lowered significantly, with China’s first quarter GDP contraction of 6.8% serving as an indication of what could be set to come for other economies.

As the fiscal policies and other stimulus programmes announced by governments and central banks start to be implemented, this should help support market sentiment. However, corporate earnings season is getting underway and likely to disappoint. As well as the longer-term effects of the crisis on certain industries and sectors, we also expect a significant rise in government debt, which must eventually be addressed.

Crucially, uncertainty over the length and depth of the recession that is now widely expected will, in my view, cause volatility to remain a factor of markets for some time.

The volatility opportunity

Peaks in volatility will tend to follow surprises in the economy or in politics, but in general, accommodative monetary policy from central banks has been a significant driver for markets over recent years. In terms of the coronavirus pandemic, moves by governments and central banks to prop up their economies and financial markets have also helped ensure liquidity, which is key for investors to be able to buy and sell assets when they want, without affecting the price of the asset.

But what are investors to make of this heightened volatility, and what is the best way to potentially navigate these uncertain markets?

Volatility plays an important role in financial markets. While it is a measure of stress and uncertainty, it can help force a reassessment of asset prices where valuations are becoming skewed. For investors with a higher long-term risk threshold, bouts of short-term volatility can offer the opportunity to pick up high-quality assets at a discount.

There are other volatility indicators, and ways to budget for risk, that investors can assess. For example, professional investors can look at value at risk (VaR) to enhance their understanding of potential dangers. This method assesses a stock or portfolio’s potential loss as well as the probability of that loss occurring. Active managers are then able to monitor the risk and the maximum potential loss of an investment.

Another indicator is drawdown – the difference between an asset’s peak and trough price over a particular period. Monitoring liquidity in the market is another way that professional asset managers can consider risk.

Tackling volatility

The best way to tackle market volatility is to be prepared for it. The coronavirus pandemic was a so-called ‘black swan’ i.e. a rare and unpredictable event which has a significant impact or far-reaching consequences – and few, if any, investors could have planned for such an eventuality.

However, periods of volatility are much more common, even if they are not as extreme or long lasting. To navigate the ups and downs of financial markets investing, investors could consider taking an active approach and maintaining a well-diversified portfolio, where their money is spread across a wide variety of different investments including cash, bonds, equites and property.

In other words, it makes sense to spread your potential risk exposure across different baskets – no matter where we are in the economic cycle – as you never know when the next black swan may swoop.

[1] Source: AXA IM