Fidelity Perspectives: Looking beyond the noise on market volatility

Portfolio Managers David Wolf and David Tulk note that recent volatility was likely exacerbated by stretched market positioning in the information technology sector, a rapid unwinding of foreign exchange positions following an expected weakening in the Japanese yen, and limited seasonal liquidity. Despite being well covered, these events have caused fear in markets. Events like these serve as a reminder to continue focusing on the managers’ four-pillar research-based investment framework. One of the pillars of this deliberate framework is sentiment; in practice, this means taking advantage of market fears rather than indulging them. The managers of the underlying funds that David Wolf and David Tulk prefer as building blocks also do this: they look for buying opportunities when sentiment regarding securities in their funds is overly negative.

David Wolf and David Tulk do not believe that the risk of a U.S. recession has increased dramatically over the past week. The most recent statement from the Fed acknowledged a softening in the labour market and a greater confidence that inflation was moving sustainably toward 2.0%. The Fed’s choice to highlight not only the progress on inflation but also the slowing in the labour market suggests that policy rate normalization could likely begin soon, and that would provide slightly easier financial conditions heading into the end of the year and 2025.

With investors facing an unpredictable economic and political landscape, Portfolio Manager Adam Kramer is remaining patient and looking to take opportunistic advantage of asset class mispricing. In a year marked by a highly consequential U.S. election and a global economic environment riddled with uncertainty, the best course of action, according to Adam, is to avoid making outsized asset class bets while awaiting more clarity. In helming his flexible income-oriented strategy, Adam dynamically pursues attractive income and value opportunities across a wide variety of asset classes, ranging from investment-grade bonds to dividend-paying equities, where temporary mispricing often causes investors to overreact to fear or uncertainty.

Adam is always aware of where we are in the cycle and looking for asset classes that have too much bad news priced into them. He believes that his investment process has a repeatable and duplicable aspect, given that the income-oriented asset classes tend to take turns each year as either the best or worst performers, only to shift the following year, as shown in chart 8

Fixed income portfolio managers Michael Plage and Jeff Moore note that cracks in the U.S. labour market are starting to open, and the Fed is starting to take notice.

The July non-farm payrolls report was soft across the board, with weak labour demand, narrow breadth of hiring, slowing labour income and a rising unemployment rate. While there are reasons to believe the weakness in the July report may be overstated, the narrative seems to be shifting away from the benefits of a falling inflation rate to the fear of a deteriorating labour market and a slowing economy. Both scenarios would result in the Fed lowering its target rate, and the odds of a September cut are now fully priced in by market participants. However, for the Fed to cut as a “mid-cycle adjustment,” or to become less restrictive, is dramatically different than easing to stimulate the economy because it detects weakness. We will understand in coming months if the Fed is behind the curve, but as Fed Chair Jerome Powell has communicated on several occasions, the Fed has the tools and knows how to cut very quickly if it thinks it is necessary – and the market is starting to increase the odds that it will be.

The managers also note that the U.S. presidential campaign season is also about to heat up. Positioning portfolios for specific political outcomes is generally not a winning strategy, but taking advantage of market volatility created by political narratives can be. For Michael and Jeff, the key to navigating these periods of heightened uncertainty is to rely on their multi-disciplined, proven, five-step process and to trust in their robust bench of experienced teammates, who know their jobs and have invested opportunistically, calmly and profitably through many cycles.

Portfolio Manager Will Danoff notes that recent market volatility provides an opportunity to reinforce long-term convictions, rather than make a reactionary shift in strategy, because he considers the pullback to be based more on technicals than on fundamentals. The economy remains robust, and his portfolio’s larger-than-benchmark positions in market-leading companies continue to show strong fundamentals. The market, trading at 17.8 times next year’s earnings, is relatively cheap, in his view, especially with declining interest rates and inflation. Notably, top portfolio names are now more attractively priced and have held up relatively well amidst significant selling in major market indexes. Will’s strategy favours large-cap tech companies, due to their leading earnings growth and strong cash generation.

Instead of repositioning defensively, Will’s focus is on leveraging volatility to strengthen long-term positions in market leaders. He views the current market turbulence as a short-term correction within a longer-term bull market. While there may be more choppiness due to seasonal factors, the election and interest rate uncertainties, the overall market remains strong, with improving corporate earnings. The portfolio’s performance has been strong throughout the year and has remained relatively resilient amidst recent market uncertainties.

Portfolio Manager Mark Schmehl notes that increased volatility in markets has been driven by a confluence of changing expectations regarding economic growth in the U.S., interest rates and mega-cap technology earnings, which has been exacerbated by the unwinding of a crowded trade. Despite the recent softer U.S. economic data and broad-based easing of price pressures, the Fed has yet to engage in policy interest rate cuts of the sort we have already seen from other global central banks.

Against this backdrop, Mark is emphasizing the need to size risks and positions carefully; he believes that understanding the fundamentals of companies, to ensure that they have strong earnings, and discerning each holding in the portfolios are crucial in Mark’s view. In the technology space specifically, Mark is being selective, emphasizing companies with durable and secular growth tailwinds.

Mark believes adaptability is key in managing the portfolios while navigating periods of market volatility, which are a natural part of equity investing. Mark’s investment strategies are flexible by design, seeking opportunities in the two tails of the market. In recent years, Mark’s portfolios have been biased toward the right tail, given the prevalence of opportunities there, but in the past, there have been periods when Mark was more biased toward the left tail. This flexibility has been crucial to the success of his portfolios over the years. For instance, Mark found good opportunities in fertilizers (2007), regional banks (2009–2010) and more. Because markets can turn quickly, Mark wants to be ready to buy stocks he likes when the opportunities arise. Accordingly, he maintains an open mind, and will not hesitate to change his positioning if market conditions change.

Portfolio Manager Dan Dupont’s view on the recent market volatility reflects a strategic approach focused on downside protection and exploiting opportunities that arise from market dislocations. The recent volatility was seen as a beneficial correction, addressing high levels of complacency in momentum trades and arbitrage. This short-term spike in volatility allowed for selective exploitation of dislocations that were available in the fund’s opportunity set.

In terms of portfolio positioning, Dan maintains a defensive stance, exploring opportunities in areas of cheapness in global markets, as well as Canada. Dan’s strategy involves staying vigilant about market conditions and making necessary adjustments to maintain a defensive posture, focusing on long-term objectives while managing short-term risks. This disciplined approach ensures the portfolio remains resilient through market uncertainties and is aligned with the goal of enhancing risk-adjusted returns over time.

Steve Dufour, Portfolio Manager of Fidelity U.S. Focused Stock Fund, believes that even though short-term volatility is challenging, it presents a valuable opportunity to prune weaker positions and upgrade the Fund’s long-term holdings. As the market broadens and the location of earnings growth evolves, the Fund aims to capitalize on uncertainty and position itself for future benefits. The economy remains robust, and the Fund focuses on companies delivering strong relative earnings growth, with market-leading fundamentals. Rather than repositioning defensively, Steve seeks to leverage volatility to enhance long-term holdings in earnings growth leaders. Uncertainty often highlights the strongest names, which maintain their resilience due to robust fundamentals amidst broader market selling.

Portfolio Manager Darren Lekkerkerker notes that short-term market volatility is a natural part of equity investing, and that over the long term, equity markets have historically followed earnings to higher levels, as shown in chart 9. Darren also notes that attempting to forecast market movements is quite a difficult task; he prefers to focus on high-quality companies that may be more resilient in uncertain market backdrops, and which may also eventually be stronger compounders. In Darren’s view, the high-quality names that make up his portfolios are well positioned for the long-term compounding of earnings, because they tend to have more stable demand, pricing power, resilient margins and strong balance sheets overall. Accordingly, while he continues to monitor the macroeconomic environment, he remains focused on ideas driven by bottom-up fundamentals.