Many market participants consider volatility as a kind of noise – something eventually canceled out by longer-term forces at play. A few short years ago, market commentators were bemoaning the lack of volatility in public markets. Bond yields were pinned to the floor by the most expansive monetary policies in memory, and partly due to the liquidity backstop provided by those policies, equity prices went on a fairly steady march upwards. Neither helped generate volatility. It wasn’t until earlier this year that a steadily tightening Fed, trade wars, Brexit concerns and domestic as well as international political turbulence finally all caught up with stocks and bonds jolting volatility into both markets. From our perch as structured private credit lenders – which is a decidedly un-volatile arena, at least by traded market standards – the shift has again illustrated the interesting contrast between what we do and what your typical long/short equity or bond manager deals with on a daily basis.
Volatility is generally assumed to rise during periods of market stress, corrections, bear markets etc. and drop/flatten when all is well (i.e. rising). This makes sense, since volume and volatility are highly correlated – at its core, “volatility” refers to the amount of market movement per unit of market volume – and volume rises during corrections as traders trade more and investors panic. All else being equal, more market participation means greater market movements in periods of rising volatility.
Traders love volatility, because it means things are moving up and down, and they can go long and/or short in what is essentially double their opportunity set. However, volatility as a price discovery mechanism can be impacted by powerful emotional responses. Sophisticated investors, accordingly, are often taught to look through the market’s gyrations as the meaningless gyrations endemic to an irrational public trading in markets, and which will ultimately revert to longer-term trends.
If there is one thing we’ve learned in nearly three decades of market observations though, it’s that those reversions can take a very long time. We’ve seen it over and over again; irrational behavior in both bull and bear markets, which then takes years to correct. As the old saying goes, the market can stay irrational longer than participants can stay solvent; volatility may be academically written off as noise, but it’s very real to the institutional investors currently nursing their wounds in both stocks and bonds this quarter. Worse, what has sometimes been garden-variety volatility has subsequently turned into once-in-a-generation events like the global financial crisis, dot-com crash, etc. and it is extremely difficult to tell the difference between the two beforehand. Sometimes, significant increases in volatility are clues that risk (and the willingness of investors to carry it) is being fundamentally repriced. It’s really only after the fact that volatility can be accurately judged as “noise.”
We’re not saying the most recent market swoon is or isn’t noise, or that it won’t ultimately revert to this or that trend. What we are saying, however, is that public market volatility is apt to increase further over the next few years. As we’ve written going as far back as 2015, stock and bond markets underwent a sea change when the Fed shifted its monetary stance; trends in place in both markets for a decade have been reversed, and we expect greater volatility going forward, not less.
Private market investments have distinct advantages during periods of high volatility. In our case, asset-based lending transactions can result in greater return consistency over time, as returns are calculated based on the performance of the underlying debt and are not dependent on the whims of public markets. We are less sensitive to mark-to-market risks than public market participants, and can thus offer a welcome port in the storm for investors looking to ride out the “noise” associated with market volatility. Moreover, many of our transactions implicitly hedge against future volatility through floating coupon rates, which in turn help support an illiquidity premium unavailable to publicly-traded instruments. These factors help create a yield cushion that can be helpful in offsetting return variability in other parts of a portfolio.