Who’s ready for vacation? After an exhausting second quarter that saw markets toggle from “crisis” mode to “return-to-normal mode”—and now perhaps back again—many investors are likely hoping for a quieter third quarter.
While we may be in “exhaustion mode,” the Great Acceleration triggered by the pandemic hasn’t slowed down. Markets could continue toggling rapidly between bi-modal outcomes, with new developments leading to outsized reactions. Investors should prepare for a summer of volatility.
How to prepare? Being reactive is likely to do more harm than good when it comes to portfolio returns. We think the more effective approach is to understand the environment we are in, structure a portfolio suited to that environment and stick to the plan.
We have three core beliefs about the current environment:
1. We think the longer-term destination is lower risk premiums across fixed income markets. We are increasingly convinced that the Federal Reserve (Fed) will keep interest rates near zero for a long time, pushing investors out along the risk spectrum in pursuit of higher yields. The pandemic is accelerating the adoption of automation and other secular trends that could make it very difficult to bring unemployment back down to pre-pandemic levels. As long as unemployment remains elevated, we think the Fed will be less sensitive to higher inflation or elevated asset markets, and more focused on its employment mandate.
2. The Fed has the tools, and the will, to achieve its goals. The central bank has shown remarkable speed and resolve in overcoming potential obstacles to its policy response. For example, as part of its policy response, the Fed said it would buy corporate bonds in the secondary market. However, companies were required to self-certify their eligibility for the program, which became a roadblock. So the Fed revised the terms of the program and began buying bonds using an indexed approach instead.
3. In the Great Acceleration, the risks—and potential market reactions—are bigger. Of the 10 biggest one-day moves in high yield spreads over the last 20 years, half have occurred in March-April 2020 (see chart). The Fed wants to prevent market disruption from interfering with the economic recovery, but we still expect to see days when the market toggles between “normal” and “crisis” mode.
