By Canada Life Investment Management Ltd., in partnership with Irish Life Investment Management and Mackenzie Investments | Nov. 22, 2021
The stock market reached record highs over the summer of 2021 as the stock market recovered from the shock of COVID-19. But with cooler weather approaching, you might be wondering how much volatility could come with it. Inflation, virus variants and a possible drawdown of unprecedented fiscal and monetary stimulus globally – all are headwinds to growth. But past market crashes and financial events across the last century continue to reinforce a tried-and-true approach: diversify your clients’ portfolios and stay invested.
To help put market volatility in perspective, we spoke with Mackenzie Investments and Irish Life Investment Managers. Both are award-winning, highly experienced investment managers that have steered clients’ investments through sustained bouts of market volatility. Although there is a long list of market events that have caused the stock market to fluctuate in the last century, we focus on recent events and what takeaways each provide.
COVID-19 pandemic
In March 2020, as COVID-19 infections were accelerating globally, countries around the world instituted lockdowns, effectively shutting down parts of their economies. The anticipation of a global recession, and the uncertainty of an unknown virus spreading exponentially, led markets to sell off sharply. The MSCI World index, a gauge of global stocks, dropped 34% from its February 19 peak to its March 23 trough.
The speed of the 2020 stock market downturn, and subsequent recovery, distinguishes the COVID-19 market event from past market crashes. In the United States, the S&P 500 recovered to its February 2020 peak in under six months, the fastest-ever rebound for a major bear market, which typically refers to a price correction of 20%.
Understanding the sources of stock market volatility
This latest major market event offers a clear reminder: market events are difficult to forecast and can be caused by entirely non-financial factors, such as the outbreak of a pandemic. Mackenzie Investments (Mackenzie) points out that researchers have found economic recessions caused primarily by financial factors generally have a longer recovery, such as the 2008 Global Financial Crisis. After the 2008 financial crisis, U.S. stocks took 5.5 years to recover to their 2007 peak, which is about 10 times longer than the 2020 event.
While the 2020 bear market was the shortest on record, it was also the deepest recession since the Great Depression. Mackenzie points to several reasons for this sharp bounce-back, including aggressive government interventions, the relative resilience of financial infrastructure and the large market weight of large technology companies, which have been less impacted by pandemic-related restrictions. This recovery highlights the sizable impact of government policy, which can both mitigate crises but also contribute to create greater volatility. This occurred during a 1981-82 event known as the Volcker disinflation, when the U.S. Federal Reserve hiked interest rates to curtail double-digit inflation.
Following spring 2020, a major take-away for Mackenzie was the continued importance of fixed income for portfolio diversification. “Sovereign [government] bonds remain an effective defensive asset in a multi-asset portfolio, even in the face of an unconventional and unanticipated shock,” says Todd Mattina, Senior Vice-President, Chief Economist, Portfolio Manager and Co-Lead of Mackenzie’s Multi-Asset Strategies Team. “As equities experienced a 34% drawdown between February 19 and March 23 last year, long-term U.S. Treasuries rallied by 12% providing diversification benefits when needed most.”
2008 Global Financial Crisis
As its name implies, the 2008 Global Financial Crisis (GFC) had a much different cause. At the time, banks and investment firms were over-exposed to mortgages granted to individuals with poor credit scores (known as subprime mortgages). While many institutions were not directly involved in the issuing of this debt, they invested in an array of products associated with these subprime mortgages.
When these subprime mortgages began to default, and the housing market collapsed, banks and investment firms were exposed to significant losses. This threatened the global financial system by creating a liquidity crisis where both access to short-term funding and the ability to convert assets to a “liquid” medium, e.g., cash, was very difficult. This crisis forced governments and authorities to intervene with support packages to rescue financial institutions. Poor regulation and supervision of the financial sector contributed to the sharp market decline.
The GFC prompted the team at Irish Life Investment Managers (ILIM) to research and implement additional equity risk management strategies. These strategies can be very important for client portfolios during protracted periods of negative equity market returns. ILIM’s approach now includes the use of strategies that provide both explicit market protection through options or strategies that offer implicit market protection through the underlying investment style or strategy.
For ILIM, explicit protection using options might involve the use of an equity collar strategy. They use this approach as part of the Canada Life Risk Reduction Pool, one of four unique risk management strategies used by Canada Life™ Risk-Managed Portfolios. This strategy helps provide some predictability and control within the portfolio as equity returns typically tend to fluctuate within a protected band. Implicit protection might include taking exposure to the low volatility anomaly. This refers to the long-standing observation that low volatility stocks have tended to outperform those with a higher risk over the long term (What happened to low volatility stocks in 2020?). Beyond finding ways to manage risk through stock selection, the team has also created a new process to address risk by managing the size of an equity allocation within a portfolio. In addition to these equity risk management strategies, diversification continues to be an important pillar in how ILIM manages market volatility.
Putting history to work
These recent market events, and those before them, provide clear evidence for the value of diversifying client portfolios. Spreading their investments globally across a wide variety of asset classes, including equities and fixed income, can help reduce their risk.
Another widely agreed upon lesson – encourage your clients to stick with their plan and stay invested. The COVID-19 crash and rebound was the fastest bear market recovery in history, which highlighted the importance of staying invested and not cashing out in response to volatility. Those who continued to stay invested during the pandemic are reaping tremendous returns from the recovery of the market.
As we help Canadians create a plan to reach their goals, it’s critical that they understand the importance of diversification and sticking with that plan. Managed solutions from Canada Life can help, with a variety of well-diversified, turnkey portfolio solutions. Whether clients are most concerned about mitigating risk, growing their investments or aligning them with their goals – there’s a portfolio for all investor types.
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