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Market participants dedicate considerable amounts of time and effort trying to answer the question of what happens next? Unsurprisingly, the focus is on ‘known unknowns’.

As the most anticipated election of the year looms large, it is tempting to try and forecast the winner, what they will do and how markets will respond. In reality, the market has already done all this work. The role of investors, therefore, should be determining what is priced-in, not what we think will happen.

It is worth remembering that the last five years have presented very obvious sources of risk, including:

Despite all the above, global stock markets have marched ever higher: the total return from the MSCI All Country World Index over the past five years has been 12.7 per year (in US dollars)1. Often, when downside risks are obvious, investors are well-rewarded for taking the ‘risk’ which then doesn’t happen.

Known unknowns: The US Election

The current consensus is that this election is too close to call, with the eventual winner constrained from implementing their full policy agenda. Regardless, the US fiscal position will almost certainly worsen. 

“Policy easing and robust growth in the US are seen as inevitable and fears over sovereign debt have gone quiet.”

Trump may politicise monetary policy setting and introduce inflationary tariffs. Harris may challenge the profit environment. A non-consensual outcome could prompt volatility. But it would be the change from certain to uncertain, or certainty about one outcome versus certainty about another, that would potentially cause dramatic price moves.

So far, market anxiety around the election does not seem as intense as in 2016. This reflects a general relaxed mood in markets, no doubt led by recent strong returns. Policy easing and robust growth in the US are seen as inevitable and fears over sovereign debt have gone quiet.

Perhaps it is counterintuitive, but calm or optimistic environments, rather than those where risks are most obvious, are those in which we should exercise most caution.

Flash crashes: Japan, carry trades and beyond

In August, the market showed how silly it can be: the Japanese equity market fell 20% in three days and the US VIX hit its highest intraday level outside 2008 and 2020. A week later, Japanese stocks were up 20% and the VIX was back to pre-August levels.

The speed of the ‘flash crash’ reversal proves it was unjustified. Stocks in Japan did not become dramatically worse, then better, in the space of a month. All that changed was prices.

Will this unjustified volatility become a market feature? Post the Japan crash, the view appears to be that recent market turbulence is reflecting structural features of our financial system. The UK Financial Conduct Authority (FCA) has said we are now in an environment of ‘predictable volatility’, exacerbated by technology, concentrated markets and centralised market participants2.

More specifically, it has been observed that certain trades, e.g. the Japanese yen, appear to be particularly crowded and leverage elevated. Crowded trades and elevated leverage causing volatility when conditions shift is not new. The issue today is the number of strategies that are participants in these trades, rapidly closing positions when these go against them.

With trend followers, volatility-targeting strategies and stop losses causing forced selling, technology could therefore be making these episodes more likely and more extreme.

Macro conditions: Unusual uncertainty

Regardless of the cause, for many investors, flash crashes are either an opportunity or are ignored. More important is the long-term risk that rising rates or inflation over many years would reverse the favourable conditions most investors have enjoyed since the 1980s – when the reverse was happening. 

Whilst it has been stated that macroeconomic conditions are ‘unusually uncertain’, we should not fall into the trap of reading too much into this: US monetary policy expectations have changed rapidly, but equity volatility has been low. Cyclical uncertainty is not unusual, it just feels like it as we look at the past with a hindsight bias.

More important than the macro shifts themselves are the fact many markets offer less compensation for these risks than over the recent past. This is as true for ‘unknown unknowns’ as for events we can see coming.

1 Source: LSEG Datastream. 5-year annualised returns to 30 September 2024, in US dollars.
2 'Predictable volatility’, Speech by Nikhil Rathi, FCA Chief Executive, delivered at FCA International Capital Markets Conference, October 2024