The recent rise in volatility has been uneven across different asset classes, but has been more pronounced in the bond market. Anthony Okolie speaks with Jimmy Xu, Portfolio Manager, TD Asset Management, about the increase in fixed income volatility and the implications for equities.
Sure, Anthony. You know, we previously talk about volatility. We typically assume that we're just talking about equity volatility, but I think the view is more nuanced now. If you look at this chart, this chart shows what market participants think where the risks are across various asset classes like equities, bonds, oil and gold. A reading of zero on this chart means that the market thinks that the volatility or the risk in the market for that particular asset class is no higher or no lower than its historical. And higher reading means that the market anticipates significantly higher volatility and lower reading means less. What's really interesting this chart is that if you look at the volatility of S&P 500, it's actually pretty much in line with historical averages. But when you look at interest rate sensitive asset classes like fixed income, gold, oil, volatility has been significantly higher. And this is really important to note because usually volatility is centered around equities, but this time it's very different, and that's something that we need to be careful with going forward.
So what's driving the differences among the different asset classes?
Well, when you think about fixed income volatility over the last 20 years or so, we've been very blessed to be living in an environment where inflation has been low and volatility of that inflation has also been very low. And central bankers globally have kept rates near zero. And the quantitative easing program. And when you put all these things together, it has really kept fixed income volatility low. However, in an environment where inflation is very much elevated, like where we are in today and central banks are really reversing their program, where we're tightening financial conditions very, very rapidly, interest rates are going up in super sized chunks over the next little while and a fairly aggressive shrink in the balance sheet. You would expect fixed income volatility to rise sharply. Basically opposite what we've been living through over the last 20 years, and that's what we're seeing. From gold, gold volatility is also elevated, which is interesting because gold is an asset class that tends to do well when there are high probability of extreme outcomes like where we are today. And inflation is obviously one of them, so that excess has kept gold volatility quite elevated. And when we think about risks in equities market, they're predominantly all risk driven, like valuations, impact from higher rates. Margin compression from inflation. And even potential recession from tightening of central bank policies. So you can clearly see the epicenter of risk today is within fixed income.
As you mentioned, volatility is much higher. We've also seen an increase in fear in the markets as well. What's your take on all of this?
I think one of the reasons why volatility and fear is so elevated right now is because we're in an environment with there's a large probability of extreme outcomes. When you have extreme outcomes that could happen, market participants tend to worry and both realized volatility and options implied volatility tend to rise. And really, there's three drivers that comes to mind. First, it's obviously the Ukraine and Russia conflict that's ongoing. I think obviously it's been a terrible humanitarian crisis. But the longer this conflict drags along, the probability of having extreme outcomes really rises and the future of Europe and their energy dependence really comes into question and that's weighing on the market and that's creating a risk premium in the market. Second is inflation. There's been lots of talk of inflation being transitory since after the effects of COVID 19 lockdowns. But what we're seeing now is potentially the impact in place to be a bit more structural and more long lasting. So markets concerned that inflation expectations become unanchored and inflation could be higher and more persistent than what people have anticipated. And this is also causing volatility, especially in a fixed income and rate space. And finally, there's a question in the Federal Reserve. They just went through this moment of they're going to do whatever it takes to keep inflation expectations anchored and to get inflation down to their 2% target. But that could mean interest rates could rise very substantially, and we're going to go through a very aggressive quantitative tightening. The risk of that, of course, if they go too aggressive, we may end up in a recession. And obviously, that creates volatility as well. So until at least we get more clarity on these three items. We should expect volatility to continue to persist in the market.
OK, so volatility is going to stay elevated. There's certainly fear in the markets, uncertainty. Can you speak to the market implications for investors going forward?
I think this is a really important point. There's a huge change in what investors need to think about. So if you think about typically the role of fixed income in a balanced portfolio is to be a diversifier, it's to reduce risk. But this has really changed now because the epicenter again of risks surrounding fixed income. What we've seen this year is fixed income has sold off and some segment market, even more so than equities, which really brings in diversification to question. From an investor perspective, they really need to rethink their assets to make sure that they truly have a diversified portfolio. Within our balance mandates, we're trying to build various layers of diversification. From an asset class mix, for example, we're introducing alternative assets like real estate infrastructure and commodities. All these things tend to do well in a rising rate environment. For fixed income, we're looking for ways to increase yield on the portfolio while at the same time reduce our sensitivity to interest rate moves. Even in the equity allocation in the equity space, we're looking to move our equity allocation towards countries or sectors that really benefit from higher inflation, higher rates. And Canada really comes to the top of line. And the dynamics that we talked about earlier, with equity volatility being lower on relative basis versus fixed income, we're buying protection in equities and funding it into the rates market. Those are the things that we're trying to do to build different layers of diversification into our portfolios.
Jimmy, thank you very much for joining us.