September's volatility—part seasonal, part fundamental

After a two-month spell of extremely low volatility in July and August 2016, inclement weather has crept back into the markets.

Elevated volatility is nothing new for this time of year; in fact, over the past 25 years, on average, September has been the second worst month of the year for the S&P 500 Index and has delivered the largest spikes in volatility as measured by movements in the Cboe Volatility Index (VIX). According to Bloomberg data, over the past 25 years, the S&P 500 Index returned an average of –0.3% in the month of September, while the VIX moved 8.8% higher.¹ Today, we're only halfway through September and the VIX has already moved from a low of 12 to a high of 18.² The key questions for investors: Is the volatility this September justified and should equity allocations be altered as a result?

To start, our network of asset managers and researchers has pointed out that there are legitimate concerns in the sources of today's volatility, the most valid being August business surveys that represent a potential drop in economic activity. The Institute for Supply Management releases their manufacturing and nonmanufacturing indexes each month to provide insight into the health and underlying trends of U.S. business activity. The August reports showed that manufacturing went from an expansionary reading in July (above 50) to a contractionary reading in August (below 50). The manufacturing index had bottomed in January 2016 at 48, but then bounced to as high as 53 in June before dropping back to 49 in August. The nonmanufacturing index similarly peaked in June and has fallen to its lowest level since 2010, at 51.³ While these readings still suggest expansionary activity in aggregate, it's clear that business activity has slowed meaningfully.

The counterbalance to slowing business activity is that the U.S. Federal Reserve (Fed) will likely take this recent economic data into consideration and push out the timetable for raising rates. The Federal Open Market Committee members have had plenty of airtime over the past several weeks and have provided mixed signals on the course of rate hikes, which has contributed to September's uptick in volatility. With the next Fed meeting coming up on September 21, investors will get greater clarity soon. Fed fund futures data now suggests that there's only a 20% chance of a 25 basis point rate hike. Those odds have dropped by half since the start of September when they were as high as 40%.⁴ As long as the Fed is patient in tightening monetary policy, our network believes risk assets, most notably equities, should continue to grind higher—albeit with bumps along the way.

There's no shortage of potential volatility-inducing events in the months ahead, including the upcoming U.S. presidential elections, a likely Italian referendum, and the possibility of Britain triggering Article 50 related to its exit from the EU. Any one of these events has the potential to rattle markets. That said, our network broadly believes that investors should stay the course with their U.S. equity allocations. With a dividend yield just north of 2% on the S&P 500 Index³ and earnings growth appearing to be bottoming, stocks could have modest tailwinds heading into 2017. Current valuations—the S&P 500 Index currently trades at 20 times trailing 12-month earnings⁴ —suggest muted equity returns in the range of 4% to 6% over the longer term. This may not sound like much, but compared with the low starting yields on bonds, it very well may be worth the risk.

1 Bloomberg, 1/1/91–12/31/15. Seasonal data is from the earliest common period for the S&P 500 Index and the VIX. 2 FactSet Reasearch, 2016. 3 Institute for Supply Management, FactSet Research, as of 9/14/16. 4 Bloomberg, as of 9/14/16. Fed fund futures data is from the world interest-rate probability function.