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Junior: What is driving the recent increase in market volatility?
Charles: Market volatility tends to increase with major headline events or when investors focus on a specific economic risk. For example, earlier in the year, concerns related to the Chinese economy, central banks’ monetary policy and falling crude oil prices caused investors to sell equities to move into cash or government bonds. Similarly, in June, Britain’s unexpected vote to leave the European Union (the so called “Brexit Vote”) triggered a sharp, but brief, market selloff. Also, quarterly earnings, where companies report results and provide commentary on their business outlooks, can unsettle the markets. Recently, the focus has returned to interest rate policies of the Federal Reserve, and those of other major central banks, as investors worry about the timing of an eventual end of the prolonged period of historically low interest rates.
During the first half of 2016, headline events including the health of China’s economy, the monetary policies of central banks around the globe and the price of crude oil dominated investor sentiment. In early January, stock prices declined on the news of a sharp correction in the Chinese stock market and further devaluation of the yuan. Recent decisions by the European Central Bank and the Bank of Japan to adopt negative interest rates raised concerns that the world economy was on the verge of recession. Disappointing corporate profits and slowing growth in China seemed to validate these fears; also, falling oil prices and a decline in manufacturing further exacerbated investor pessimism. Indeed, the major stock indices recorded their worst ever results in January. Against this backdrop, the Federal Reserve modified its expectations for upcoming rate hikes. The Fed’s policy shift, along with more positive economic data, sparked a stunning relief rally: the S&P 500® Index, which had fallen more than 10% by mid-February, rebounded with the largest recovery for any quarter since the Great Depression; by the end of March, the Index was in positive territory.
On Thursday, Great Britain stunned the world markets when it voted to leave the European Union. Betting odds and the economic benefits supported the widely-held assumption that the Remain vote would win. The Leave result triggered not only a worldwide market selloff but pundits immediately criticized the decision as a disaster for the UK with the potential for causing the EU’s disintegration. This development, following a two-year bear market in oil, actions by China to migrate to a more consumer-driven economy, and speculation on interest rate increases, was yet another unwelcome intrusion as the markets struggled during the recent period of moderate economic growth.
Understandably, investors are unsettled and unsure as to the decision’s long-term implications. Taking a step back and looking at the bigger picture is important in evaluating the impact of the vote.