• Market volatility can be categorised into three different types of risk, each with their own distinct characteristics. 

• Current market volatility is driven by economic-related concerns, including global policy uncertainty. 

• Maintaining a balanced portfolio is key to managing risk amid elevated market volatility. 

Historical context can be a powerful tool for understanding volatility. Rising market volatility generally reflects one of three types of risk: 

• Episodic: Characterised by short-lived, albeit legitimate, risk events that prove to be less enduring - often with the benefit of hindsight. A good example of this would be from August 2024 when a report suggesting weakness in the US labour market combined with a crowded carry trade¹ created a spike in volatility which dissipated within a week. 

• Economic cycle-driven: A rise in volatility often linked to economic slowdown and the fear—and sometimes the realisation—of recession. A notable instance includes the 2001 recession in the US which followed the bursting of the dot.com bubble. 

• 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. 

Volatility is likely to remain in play 

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

Firstly, 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. 

Secondly, 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 which will define the decade ahead - an artificial-intelligence (AI)-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 labour 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 a requisite premium should it deem that warranted. 

Thirdly, the US Federal Reserve 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. 

Investor implications 

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 an investor’s risk tolerance and time horizon get out of sync with their portfolio.  

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

¹ A strategy where investors typically borrow in a currency at a lower interest rate to invest in assets where returns are potentially higher.