Over recent weeks, investors have been shaken by the sharp selloffs across global risk assets, with the most speculative assets declining the most. Since the beginning of April, the S&P/TSX Composite Index has lost 8%, the Nasdaq has tumbled 20% and bitcoin has fallen more than 34%.¹ We believe the main catalyst for the selloff, especially in growth assets, has been the change in the interest rate regime. Higher rates disproportionately impact growth equities because their expected earnings are weighted towards the distant future, making them more sensitive to changes in the long-term discount rate. Since the beginning of April, 10-year U.S. Treasury yield has moved 0.5% higher, led by increases in real yields amid Federal Reserve hawkishness and higher-than-expected inflation prints, putting more pressure on growth focused companies, especially ones that are not yet generating positive cash flows. ² Thanks to rising rates, bonds have done little by way of ballast, sinking in tandem with equity markets.

Real rates move positive (U.S. 10-year Treasury Note)

Interest rate decomposition

Source: BlackRock, Bloomberg. Chart by iShares Investment Strategy, as of May 19, 2022. Nominal rate represented by U.S. Generic 10 Yr. (USGG10YR Index), Inflation Breakeven represented by U.S. Breakeven 10 Year (USGGBE10 Index), and Real Rate represented by Federal Reserve U.S. Treasury H15 Constant Maturity 10 Yr. Real Yield Curve Rates (H15X10YR Index). Index performance is for illustrative purposes only.  Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Another contributing factor to volatility has been the unwind of Quantitative Easing (QE), a monetary policy strategy used by the Fed and the Bank of Canada to lower borrowing rates and reduce market volatility. From March 2020 to March 2022, QE supported a rally in almost every asset class, from investment grade corporate bonds to U.S. equities. Now, as both central banks shrink their balance sheets, the process is working in reverse, with interest rates and volatility rising.³ The CBOE Volatility Index (VIX), a barometer for U.S. equity market uncertainty, has jumped to the highest level in 12 months. In turn, U.S.-listed ETF trading volumes also reached 39% of all U.S.-listed equity trading in the month of May, up from a YTD monthly average of 32%.⁴ Generally, spikes in ETF trading volumes signal an uptick in market stress.

The path toward higher rates and greater volatility does not have to proceed in smooth incremental steps. As the current situation shows all too clearly, volatility has historically tended to increase more in episodic jumps than through a steady linear direction. Still, as the market adapts to a higher interest rate regime and tighter financial conditions more broadly, we don’t anticipate the violent swings in price action that have characterized 2022 year-to-date to remain the norm. Economic data in the U.S. and Canada remains strong, and volatility notwithstanding, we do not foresee an imminent recession on the horizon.

Min Vol relative performance vs. broad market indexes (in CAD terms)

YTD performance

Source: Bloomberg, data as of May 19, 2022

At times like this, we believe it would be wise to be in risk management mode, with a diversified approach incorporating defensive factors such as quality and min vol, dividend exposures, shorter-duration bonds and floating rate funds. Moving to cash is far from the ideal solution, not least because of inflation. Instead, we prefer building portfolio resilience within asset classes, for example, through the quality and minimum volatility factor exposure in funds like the iShares MSCI USA Quality Factor Index ETF (XQLT) and the iShares MSCI Min Vol USA Index ETF (XMU). With elevated equity volatility, the min-vol factor has outperformed the broader S&P 500 Index by more than 4.5% YTD. ⁵

Additional resources

Source: BlackRock, Bloomberg; data as of Apr 30, 2022. Fund performance since inception (annualized): 9.8% for XMV, 14.3% for XMU, 7.9% for XMI, and 5.3% for XMM.