From nuclear tensions with North Korea to turmoil on the streets of Charlottesville, political risks have been hovering over equity markets again. We think investors should be on alert for a potential resurgence of volatility.

Volatility can’t stay low forever. Over the past year, US and global equity market volatility has fallen to the lowest levels in the past decade. Many investors have been concerned that such extremely low volatility might indicate that a potential reversal could be dramatic.

COMPLACENCY BREEDS IMBALANCES

These are reasonable concerns. Low volatility often induces complacency, which can create market imbalances that snap back violently. For example, when volatility is extremely low, investors may think that risky assets are less risky than they really are. This perception fuels an inflation of prices that may result in a sharp correction.

Of course, there are plenty of good reasons for low volatility today. Global economic growth is continuing at a moderate pace. Inflation is generally benign. And even concerns about rising rates may be a bit overdone, given that the US Federal Reserve is likely to raise rates gradually.

However, it’s been a very long time since equity markets have experienced a major downturn. We haven’t seen the S&P 500 fall by more than 10% in 79 weeks. On average, the US market has fallen by that much every 33 weeks since 1928.

IT’S NEARLY IMPOSSIBLE TO TIME THE MARKETS

None of this means that a significant downturn is definitely on the horizon. Volatility levels, like valuations, can’t tell you when a correction will occur. And even skillful investors who closely monitor macroeconomic signals, market risks and political hazards rarely predict the trigger for a change in sentiment and an inflection point in the market.

That’s why investors need to prepare now. We believe that lower-volatility equity portfolios can play an important role in cushioning the downside. But there’s a catch: the recent low volatility has coincided with a period of extremely low interest rates. When rates rise, many lower-beta stocks, which often behave like bond proxies, are likely to underperform (Display).