Wednesday, May 24th, 2017

Comforting Conclusion

There is always something to write about, even when markets are not moving. To make it sound scientific, we will call it low volatility and start our 600 words. Back in January, we first introduced the theme of ultra-low volatility: the idea that the aggregate realised volatility of all the major asset classes available to US institutional investors would fall to 20-year lows at some stage during this year. To measure this, we constructed an index based on the weekly dollar returns of 5 equity regions, 4 categories of fixed income and 2 alternatives – real estate and commodities. To keep it simple, we measure each asset class against its own median volatility (median = 100) and take the unweighted average.

The current index value is 68, which compares with a low of 63 in July 2014 and 64 in February 2007. We normally find that US domestic assets, like Treasuries, REITs and Equities, hit their lows a few months before international asset classes, like non-US equities and EM Bonds. However, this time the move to ultra-low volatility is more synchronized, which increases the chances of setting a new low for the index as a whole. The asset classes with the lowest volatility relative to their own history are Japanese Equities (38); UK and US Equities (both 50). The highest are EM Bonds (81) and Commodities (80).

Having made the prediction, we are no longer interested in whether we actually set a new record. The questions now are: how long can we stay at this very low level; what happens next; and are there any individual asset classes which we should be watching?

Using the last two examples; we find that the period of ultra-low volatility (70 or less) lasts about 4-5 months, though it can be longer for individual asset classes. Last week was the first reading below 70 in this cycle; which by extrapolation takes us through to October 2017. For those of a superstitious nature, this would be the 30th anniversary of Black Monday.

However, just because we expect volatility to rise, it doesn’t mean we have to forecast a doomsday scenario. From July 2014, the index took ten months to get back to a reading close to 100, and then it fell back to 85. From February 2007, it took eight months to get to 100 and it then rose to 110, at the time of the Bear Stearns rescue in March 2008. Another way of looking at this is to say that the last global equity correction, which troughed in February 2016, added 35 points to the aggregate index, which would push it almost exactly back to the 20-year median. This is actually quite a comforting conclusion because it suggests we can take a 10-15% correction in equities, without investor psychology being badly affected.

So finally, are there any particular asset classes we should be looking at? In 2014, the asset classes which led the increase in volatility were Commodities, US High Yield and US REITs. In 2007, they were Eurozone Equities, Japanese Equities, US High Yield and US REITs. May be this is a coincidence, but we shall certainly be paying attention to the two US assets, both of which have obvious connections with the US interest rate cycle. US High Yield is currently at 64, but is now very sensitive to the impact of OPEC on the Energy sector. US REITs are currently at 79, having fallen from 107 at the end of March.

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Thursday, May 18th, 2017

Peak Euphoria

It is not often that we write about the active weight of our recommended Eurozone portfolios, but – believe it not – something quite interesting has just happened, following the French elections. Active weight measures the extent to which the aggregate underweight and overweight positions differ from their benchmark weights. We consider two portfolios, Eurozone government bonds and Eurozone equities, both allocated on the basis of countries. The active weight of the bond portfolio has reached a two-year high in the same week as the active weight of the equity portfolio has hit a two-year low. Investors are happy to take big country bets in the Eurozone bond market, but do not want to replicate these bets (or any other bets) in the equity market. What’s going on?

The first half of the question is easy to explain. Now that the risk of Mme Le Pen as President has been completely removed, the chances of a euro-crisis are held to be much lower, and investors are free to avoid ultra-low yields in the core and buy the periphery, apart from Italy. But why is this divergence not reflected in the equity market? If the active weight carries on falling at the same rate as it has for the last month, by early June it will be challenging some of the all-time lows, set in 2013, 2009 and 2002. These levels are always associated with the onset of – or a recovery from – financial or political crisis. And herein lies the clue. If the Eurozone is now “safe” for equity investors, the first thing they have to do is buy the benchmark. They can worry about sector and country tilts later. It doesn’t matter whether they are domestic investors getting out of bonds or international investors diversifying away from the US, beta is more important than alpha. They need to increase their weighting before the end of the quarter./p>

History is full of examples of these periods of indiscriminate buying. Although neither President would be flattered by the comparison, the most recent parallel for the Macron trade is the Trump trade, from November 2016 onwards. In local currency terms the chart is almost identical, if we date it from the first round of the French elections. For international investors the effect has been compounded by currency movements with the euro and dollar both strengthening after the results were announced. Remember this is the whole of the Eurozone equity market, not just France./p>

So how long does this euphoria last? Nothing in this paragraph should be taken as an indication that Eurozone equities cannot make further progress in the short term. However, they already account for 37% of our model portfolio and this is unlikely to get much higher. Since the start of QE, there have only three previous occasions where its exposure to any equity region has been greater than 30%: EM in July-August 2009, Japan January-May 2013, Eurozone November-December 2013. In this respect the Macron trade is already more powerful than the Trump trade, which peaked at 29% of our portfolio in February 2017. Even if there is no challenge from another equity region, a correction in global equities could well require us to increase our weighting in fixed income. Our exposure to the Eurozone hit 30% at the end of March. In terms of time spent above this level, it is already the second-longest run behind Japan in 2013. This, together with our evidence of indiscriminate buying, makes us think that we are already at peak-euphoria./p>

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Wednesday, May 10th, 2017

Prices Move Before News

Every now and then the newspapers allow their correspondents to write an opinion piece which starts with a phrase like, “who could have predicted…”. The desired answer, of course, is no-one. This thought is prompted by the rash of articles which have greeted the election of President Macron, all harking back to the big gamble he took in setting up his own party a year ago. Other recent articles have focussed on the impossibility of predicting the rally in Greek bonds and the behaviour of the oil price. We have a long standing aversion to forecasts of any sort. This allows us to have an uncluttered view of what is happening in financial markets. We never claim to have the sole lease on wisdom or to identify every important trend in real time, but our hit rate is really quite good. The only way to illustrate this by reference to the charts we published in real-time.

At the start of 2017, French elections were just one piece in a complex narrative about the rise of populism in Europe and the first test was the Dutch Parliamentary elections in the middle of March. Our exposure to Eurozone equities saw a big increase in early March as opinion polls showed that the PVV, the right wing party led by Geert Wilders, was no longer likely to be the largest party in Parliament. By the end of March, Eurozone equities were our preferred equity region and the largest single exposure in the portfolio, where they remain today. During that time the Eurozone has outperformed the US, the previous #1, by 10.7%. The perfect time to have switched out of the US would have been two weeks earlier, which would have produced an outperformance of 14.4%.

Regarding the rally in Greek bonds, we have had an overweight position against other Eurozone government bonds since the second week of November, during which time they have outperformed by 11.2%, against a “perfect” score of 21.6% if we had gone overweight four weeks earlier. None of our models invest directly in commodities, but we can track our recommendations for the Energy sector vs the US equity index. We moved to underweight in the third week of February, since when the sector has underperformed by 10.5%. Perfect timing would have involved selling in December 2016, at a 15-month relative high, to avoid underperformance of 16.6%.

These are, of course, examples we have selected, but only in response to what the business pages have published over the last week. We never get the perfect score, buying at the bottom and selling at the top, but over the years we have learnt that prices move before news, and certainly before there is a detailed explanation of all the underlying issues. Here are some of the charts we are currently watching.

(1) The Materials sector is under pressure in our regional equity models for China, the UK and the Eurozone. Two weeks ago we downgraded to Neutral in the Eurozone; this week we downgrade to Neutral in China. We expect the UK to go to Underweight shortly.
(2) This week we downgrade China to Underweight in our global equities model.
(3) We have not had confirmation, but we think that dollar-denominated EM sovereign bonds have peaked in our fixed income model. This is to be expected if China and the commodity-related sectors remain under pressure.

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Thursday, May 4th, 2017

Bi-Modality

We read lots of discussion about the current ultra-low level of volatility in the US, which is a theme we first mentioned in January. Most of it is framed as discussion about the Vix index, but we prefer to talk about realised volatility because we think it is a broader measure of investors’ experience of risk. It is also the single the most important influence on the pricing of implied volatility.

Figure 1 shows the frequency distribution of realised weekly volatility for the S&P 500 from 1995 to 2016. Most investors understand that realised volatility is not normally distributed and would expect to see a long tail on the right side of the distribution, where there are a small number of extreme readings. These have important implications for the maximum loss which US Equities are exposed to. However, investors may not know that the distribution is also bi-modal. It has two peaks – one at 10.5% and the other at 16.0% and there is a big valley between them. The median observation, which is 14.5%, has a much lower frequency than the two modes and their surrounding levels.

This is important because it suggests there are two separate regimes for realised volatility rather than one continuous one, and this will influence implied volatility as well. So, the question for investors is not just whether volatility will rise in the near future, but how likely is it to switch from one regime to the other.
So far we have focused on the US equity market, but the distribution of realised volatility is not the same in other developed equity markets, such as the UK or the Eurozone. The mode for the UK is 8.5%, but the next three highest frequencies come at 11.5%, 13.5% and 17.5%, and none of the intervening valleys are as deep as in the US. The median observation for the Eurozone is 17.0%, which is quite close to the mode at 16.0% and the distribution is more or less normal, apart from the expected right-hand skew. The same is true for Japanese equities, but with slightly different numbers.

If there are two regimes in the US, this makes it different from the rest of the world. Investors should be aware of this, even if we can’t explain it. One possible explanation would be the existence of a group of agents who tend to seek protection when equities are volatile and their solvency cushions are low, but who switch to selling protection and receiving a premium when volatility is low, and their balance sheets are “whole”. It would not be surprising if more of these agents were operating in US financial markets than elsewhere.

Disentangling this behaviour from the actions of the FOMC is beyond the scope of this article. However, we have always believed that the primary transmission mechanism of QE was not the suppression of bond yields stimulating investment in the real economy, but the provision of abundant liquidity, allowing financial intermediaries to hang on to impaired investments, thus reducing financial market volatility. It seems likely that a group of sophisticated agents who are prepared to buy and sell volatility, would also understand this. The danger is that they all stop selling protection, and start buying it at the same point in this hiking cycle. An incremental change in Fed policy could cause a non-linear move in implied and realised volatility. The data suggest the US is more susceptible to this than other markets.

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