Recoveries Are Rarely Straight Lines

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Neuberger Berman

We believe more volatility is likely, and think investors should diversify against it but also use it to lean into the new cycle.

As we came into 2021, two big things were on our minds in the Multi-Asset Class team.

The first was the risk inherent in the strong investor consensus for an early cycle recovery as economies reopened and stimulus gained traction.

The second was how this reminded us of the beginning of 2010, a year that started with post-crisis optimism and ended with global equities up by 10%, but also endured a 12% drawdown.


Over recent weeks, our first concern has been justified. The consensus has been disturbed by inflation fears, raising worries about tighter monetary policy, higher bond yields and the interest rate sensitivity of equity markets.

Once a consensus has been challenged, as it was in 2010 by the Eurozone crisis, volatility tends to follow. And while we have experienced some volatility, particularly in Treasuries and interest rate-sensitive large-cap growth stocks, at the stock market index level so far this year we have seen only a 3.5% drawdown at the end of January and a 4% drawdown since mid-February.

That’s a long way from the swoons of 5% and 10%-plus that we got in 2010, and indeed the level of volatility the equity index option market is pricing for today. The CBOE S&P 500 Volatility Index (VIX), after several years at subdued levels, has priced for 20%-plus annualized U.S. equity volatility since its spike last March. That is consistent with the dips we saw in September and late October. Even accounting for the premium baked into option pricing, it implies that the market should anticipate similar 5 – 10% drawdowns still to come.

With that in mind, we think investors ought to consider how their portfolios are set to weather that potential volatility, but also how they might take advantage if and when it arrives.


When the primary cause of equity market volatility is rising rates, the traditional portfolio diversifiers, government bonds, are unlikely to offer protection. They are down some 3 – 6% so far this year, and more than 10% further out on the curve. The Merrill Lynch Option Volatility Estimate, sometimes called the VIX for bonds, spiked even higher than the VIX itself at the end of February.

Alternative diversifying assets might be those exposed to a recovery in growth and inflation, but reasonably priced because they have been neglected for so long, such as Treasury Inflation-Protected Securities, and those less exposed to changes in rates, such as commodities. Credit is interesting, too: Brad Tank has explained why it has been spared much of the volatility in equity and government bonds.

Liquid alternative strategies that specifically seek out return sources uncorrelated with equity and bond markets also have a role to play. Some of these strategies address markets that currently offer attractive value, such as Insurance-Linked Strategies.


Taking advantage of potential volatility can also mean adopting a more tactical approach.

At the start of the year, we were concerned about the level of short-term consensus even though we ultimately agreed with broad consensus views over the 12-month horizon of 2021. Our solution to that dilemma was to implement relative value positions across portfolios that stood to benefit from early-cycle reflationary growth while cutting allocations that we considered to be most at risk from the consensus. Examples were being short fully valued and interest rate-sensitive U.S. large caps, but long U.S. small caps and Japanese equities.

During the volatility at the end of January and the end of February, we were able to make those exposures more directional—by maintaining the longs in U.S. small caps and Japan but cutting back the short in U.S. large caps, for example. We also took the opportunity to add to markets that are particularly exposed to early-cycle recovery with relatively attractive valuations, such as the U.K.’s FTSE 100 Index.

Should we experience further bouts of higher volatility, as we anticipate, we will continue to make these tactical adjustments. Should equity markets defy gravity and only experience modest 3 – 5% drawdowns for the rest of the year, we will be content to draw the potential income from the mismatch between implied and realized volatility by holding equity index option PutWrite strategies.

Recoveries are rarely straight lines, but a straight line was implied by the consensus at the beginning of the year. We share that fundamental optimism, but we also seek to diversify against short-term risks and believe it is prudent to lean portfolios into this new cycle as volatility creates better entry points through the year.

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