Exogenous events

By Salvatore J. Bruno, Chief Investment Officer and Managing Director for IndexIQ

Just when you think it’s safe to go back in the water, along comes another of those aptly named “exogenous events.” This time it was the strike in Iraq, conducted by the Trump Administration in early January. The first reaction of the markets was to sell off as traders waited to see how the world, particularly Iran, would react.

While investors generally keep a close eye on the Middle East, it’s hard to anticipate an event like this. The attack took place overnight, and markets sold off, but by the time stock exchanges opened the next morning equities were already well off their lows. Still, they were down for the day and, as analysts noted, future movements were likely to be dictated by whether or not there was an escalation in hostilities.

Fortunately, in this instance cooler heads seem to have prevailed, at least for the moment, but that may not always be the case; sometimes things take on a life of their own. The point for investors is that neither the nature nor the timing of these exogenous events can be fully anticipated. What can be anticipated is that something unpredictable will predictably occur and that volatility will follow. Preparing for that is not a matter of reacting in the moment, it’s a part of long-term planning.

Decades of globalization have compounded the impact of exogenous events, as they reverberate more quickly around the world. A tsunami in Japan, a financial crisis in Greece, an attack in the Middle East – the impact is quickly felt in the financial markets and may, in some cases, percolate into the economy with longer-term consequences. A report from the Federal Reserve Bank in Atlanta (Fall 2011) highlighted how these linkages work. It noted that following the March 2011 tsunami that struck Japan, U.S. auto and parts production fell about 7% resulting in a -0.6% decline in the U.S. manufacturing sector in April of that year. Consumer spending on autos and auto parts fell, too, contributing to a “rapid deceleration in the overall gross domestic product growth in the second quarter (2011),” the Atlanta Fed said. Stocks dropped. These impacts were significant and almost immediate, but they were also transitory. Japan eventually recovered, as did stocks and the auto parts market.

Earthquakes and tsunamis are classically “exogenous” – outside the norm, impossible to predict. Political events – elections, for example – have a known timeline but a sometimes unpredictable result (think “Brexit” and Trump v. Clinton in 2016). All can be disruptive and can trigger short-term investor behaviors that undermine long-term goals. Portfolio diversification, including the use of liquid alternative exchange-traded funds (ETFs), can help manage this volatility while maintaining exposure to both the fixed income and equity markets. Managing volatility, in turn, makes it easier for investors to stick with their plan.

It’s easy to think we live in historically volatile times, though a look back at the century past (two world wars, the Great Depression, the Cold War) belies this. But we do live in a period when the volume of information – and the speed at which it moves around the globe – is unprecedented. News reaches us faster, and with greater impact, than ever before. That makes managing emotions that much harder and reinforces the importance of planning, and the use of liquid alternative exchange-traded funds (ETFs), in helping investors to reach their objectives.