Charting the Market: Russia-Ukraine War Sparks Volatility
Russia’s unprovoked invasion of Ukraine has taken a grave human toll and ushered in a new era of geopolitical conflict. The Russia-Ukraine War also has led to a significant market dislocation, with currency, stock, and bond volatility increasing to one-year highs.1
This month’s Charting the Market puts the current market dislocation in historical context.
Volatile, Non-linear Market Movements Make Market Timing Difficult
As the Russia-Ukraine War unfolds, certain market segments may see sentiment turn positive or negative based on their relationship to the most impacted macro variables. Commodities, energy, and inflation-related market exposures have witnessed strong gains given how important the Russian-Ukraine region is to the global commodity complex, and how the derivative impact of higher prices may result in elevated inflation readings. And flows have followed those returns.
Yet, those movements have come with higher volatility and are non-linear. Meaning there are “higher moments” of skew and kurtosis associated with the return and intra-market dispersion of those segments. This limits the ability to forecast market movements with absolute confidence beyond ultra-short-term time periods.
What’s more, market reactions can be counterintuitive (e.g., on the first day of the invasion, the broader S&P 500 Energy Sector fell on the day). This unpredictability will continue as the endgame and consequential impacts of the invasion are unknown.
Figure 1 below underscores the difficulty of market timing. Using returns on the S&P 500 Index dating back to 1950, average subsequent 6-month returns following the worst 20 one-day returns is 27%. In fact, only two time periods saw negative returns, and only one of those was double digits.
Lengthening the time period only magnifies this outcome, as the average return increases to 52% and there were no periods of negative returns. Taken together, if an investor decided to rotate out of equities entirely based on severe market declines, history shows the opportunity cost of doing so has been significant — and persistent.
Cross-asset Volatility Shocks Underscore Power of Diversification
Given there are a number of known unknowns related to the war, 30-day realized volatility on the S&P 500 Index is in the 92nd percentile historically (dating back to 1950).2 So even though the market is up (S&P 500 Index +3%, MSCI ACWI Index +0.7%) since the invasion started, volatility has been elevated.
In fact, as of March 3, the S&P 500 Index has had 12 days of gains or losses greater than 1% over the last 20 trading days.3 Put another way, 60% of the time the index has either risen or fallen by more than 1% during this short timeframe. This frequency is much higher than the typical average (4 days out of 20) and sits in the 96th percentile historically (also dating back to 1950).4
Beyond end-of-day measures of return volatility, we are also witnessing more frequent intraday changes. This is reflected with a calculation of intraday return volatility, a metric that is historically in the 86th percentile (since 1990).5
With this volatility backdrop, where price swings are elevated and not following a normal distribution pattern, now is precisely the time to trust in diversification. Rely on traditional risk mitigation tools (e.g., Treasuries, gold, liquid alternatives) to play the role they were designed to play in your portfolio.
The power of diversification, particularly when there are cross-asset volatility shocks, is on display below. As shown, owning just defensive Treasuries may not be enough if volatility impacts multiple asset classes and uncertainty is pervasive.
As Spreads Widen for Less Liquid and Emerging Market ETFs, Monitor Liquidity
Not all markets have the same liquidity profile, nor do all ETFs that seek to track those markets. We know that bond markets are more illiquid than stock markets, and US large caps are more liquid than US small caps.
For example, the implied liquidity within the US large-cap market is eight times greater than for international large-cap developed stocks ($28 billion to $3 billion),6 based on the amount that could be traded without a transaction representing more than 25% of an underlying stock’s average daily volume. Once you go further outside the US, that figure changes drastically, as the implied liquidity on emerging market large-cap stocks is $674 million.7
ETF liquidity has similar differences and is just as important to understand — particularly during volatile time periods when less liquid ETFs can see their bid-ask spreads widen more than highly liquid ETFs.
For example, as shown below, as of March 3 the average bid-ask spread on the least liquid US Equity ETFs widened by 10% compared, on average, to their prior 30-day average. This compares to just 5%, on average, for the most liquid US Equity ETFs.
Given that the US market is a more liquid segment, the bid-ask spread widening based on secondary market ETF liquidity was more pronounced in other asset class exposures — especially within emerging markets.
Amid Volatility, Proceed with Caution
Hopefully, this information helps you navigate investment-related decisions and client conversations in the days and weeks ahead. Remember to stay focused on long-term goals and the overall diversification of your portfolio. And if you must trade, do so carefully and in a fully informed way.
Finally, it is difficult to witness the destruction and human suffering taking place in Ukraine. Offering assistance to those impacted and finding ways to support those affected may help mitigate the helplessness people feel in the face of war and its consequences.
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