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In brief
• The pull-back in equities since the start of October is not the result of one event, but a multitude of building risks.
• Pockets of heightening volatility, rather than structural higher volatility are becoming more common. These periods may feel more severe against an extended phase of relatively benign volatility, but are often short lived.
• The potential for strong returns in the final stages of the market cycle provide an incentive to remain invested. Rather than recoiling from equity markets broadly, investors should consider the resiliency of their portfolio and whether portfolios are adequately diversified.
VOLATILITY RETURNS WITH VENGEANCE
Equity investors have started the final quarter of the year on the back foot. The Standard & Poor’s (S&P) 500 has declined 6.3% since the start of October and the largest daily drop since February of the year was recorded last week. The slide in U.S. equities has been felt globally with most major regional equity indices falling sharply and the volatility rising. The Chicago Board Options Exchange volatility index (VIX) has risen to close to 25, more than doubling from the start of the month.
There is no one cause behind the acute decline in equities, but it’s the result of compounding market fears on a number of macro and micro events. The specter of rising rates still haunts markets, despite this reflecting improving growth. Markets have been adjusting to rising rates, but similar to the equity retreat February, the pace at which yields have moved caused multiples to come under pressure and volatility to rise.
Anxiety is also being fuelled by the worsening U.S.-Chinese relationship, spilling out beyond trade disagreements and showing little sign of a near-term resolution. Now that the rhetoric around higher tariffs is becoming reality, companies are warning of higher input costs that may crimp what have been steadily rising profit margins and the upcoming U.S. earnings season. All of this comes at a time where borrowing costs are rising, and appear amplified against the late cycle narrative.
The surge in volatility has taken the level of the VIX above this year’s average of 15.1 but sharp spikes in volatility are not uncommon. Going back to 1990, the average level of the VIX index is 19.2, however, over the past five years the average has been 14.5. The more benign environment makes the breakouts in volatility seem more severe, but remain below historical averages. Moreover, periods of elevated volatility are becoming shorter. The market correction in February of this year was associated with a VIX above 35, higher than today’s figure, but returned to its long-term average nine days later. Market volatility has shown that it returns to more normal levels unless it is associated with an exceptional event. The current combination of market worries does not appear exceptional against the backdrop of still generally strong economic growth.
Investment implication
A busy political and corporate calendar over the coming weeks could keep markets on edge, but equity markets will eventually find their footing. Market corrections come part and parcel with investing, but without a high probability of a near-term recession, a bear market is unlikely. The third quarter of the U.S. earnings season will be crucial and could help anchor market sentiment. Even the possibility of lower earnings growth and higher rates could be offset by an adjustment in valuation multiples. This does not imply the end of the bull market run, but more moderate returns. The potential for strong returns in the final stages of the market cycle provide an incentive to remain invested. Over the course of the prior two cycles the S&P 500 has delivered in excess of 30% two years before the end, and 15% one year out.
Rather than recoiling from equity markets broadly, investors should consider the resiliency of their portfolio and whether they have the correct diversification-whether through diversified fixed income, alternative strategies, or simply more defensive income approaches-in place to protect against periods of higher volatility and market pull-backs. 

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Published by Ian Hui, Global Market Strategist, J.P.Morgan Asset Management

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