Not all market volatility is created equal

Rising market volatility generally reflects one of three types of risk:

• Episodic: Characterized by short-lived, albeit legitimate, risk events that prove to be less enduring—often with the benefit of hindsight. A good example comes from early 2018, when concern about rising interest rates and an unwinding of levered short-volatility positions led to a short-lived spike in volatility. August 2024 provides another, more recent, example, when a soft jobs report and a crowded carry trade unwinding worked together to create a volatility spike that dissipated within a week.

• Economic cycle-driven: A rise in volatility often linked to economic slowdown and the fear—and sometimes the realization—of recession. Notable instances include the bear markets of 1980–1982 (when the Paul Volcker-led Federal Reserve was taming inflation), the 2001 recession that accompanied the dot-com bubble burst, and the 2022 bear market, which was driven by a spike in postpandemic inflation and the Fed’s interest-rate-hiking cycle.

• Existential: The prospect of a systemic collapse of the economy and/or the financial system that can drive periods of unprecedented uncertainty and extreme market downturns. This is a “once in a generation” type of risk. Recent examples include the global financial crisis of 2008–2009 and the initial phase of the COVID-19 pandemic in 2020. “Economic freefall”—a phrase commonly used by commentators to describe such events—captures the sentiment well.

The current market volatility is not driven by existential or episodic risk concerns, but by economic cycle-driven concerns. Accordingly, it is likely to prove somewhat durable—think weeks and potentially months, not days—for three broad reasons.

First, the depth and breadth of policy uncertainty is a global dynamic, and the uncertainty remains at historically elevated levels in some countries. Some initiatives also carry the potential to weigh on economic growth while adding pressure for higher prices.

Second, apart from policy uncertainty, deeper currents driving the economy are likely to be more disruptive than before. As Vanguard’s global chief economist underscores, the economy is going through the initial phase of what we consider to be the contest between two megatrends to define the decade ahead—an artificial-intelligence-driven productivity boost and the weight of a secular rise in structural fiscal deficits on the economy.

As AI spreads through the economy, the implications for the labor markets and competitive dynamics for many industries will be anything but trivial. With the potential tectonic shifts underpinning the transition, the tug-of-war may manifest in disruptions that challenge the status quo. At the same time, the bond market is likely to continue to pay close attention to the evolving debt dynamics and may not hesitate to price in requisite premium should it deem that warranted.

Third, the Fed approaches this confluence of forces with inflation not having returned to its 2% target. If inflation rises anew, policymakers, concerned not only with full employment but also with price stability, may feel constrained in their ability to support the economy through interest rate cuts. 

A true hallmark of a balanced portfolio is the ability to withstand the inevitable (and unpredictable) periods of significant drawdowns and remain invested in equities in pursuit of eventual capital appreciation. The equity risk premium—the higher returns investors expect stocks to deliver—comes with the potential for a volatile ride. It’s important not to let one’s risk tolerance and time horizon get out of sync with the portfolio. 

After years of stock market outperformance primarily driven by growth tech firms in the U.S., some investors may be overallocated to U.S. equities. At least some of them may benefit from recalibrating their stock-bond mixes so that their fixed income allocations can act as effective ballast when equity prices tumble. Others may benefit from adjustments within their equity sleeve, restoring the balance between U.S. and ex-U.S. and/or growth and value stocks.

The recent volatility highlights an important lesson about downside risk: that the nature and scope of true downside risk are often unknowable. The investors who are most likely to succeed in the face of elevated volatility are those who’ve positioned their portfolios to withstand the inevitable vicissitudes of the economic and market cycles.