Wednesday, August 23rd, 2017

Winter Is Coming

With apologies to all fans of A Game of Thrones, and those who have yet to become addicted, the problem with motto like the title is that it is very easy to sound like a perma-bear. In the TV show we were introduced to the theme in the first episode of series 1. We are now at the end of series 7 and it has only just arrived. If the show had only been about the onset of winter, the producers would not have had enough material to fill two series, let alone seven. In entertainment, as in investment, it’s what you do between bear markets that really matters. The opportunity cost of always being ready for winter can be huge.

As we return from this year’s holiday period, our US asset allocation model is resolutely pro-equity, though there is no shortage of threats which could rapidly alter this position. Our non-exhaustive danger list is probably no different to anyone else’s: a property crash / credit crunch in China, failure by the Trump administration to advance a significant tax reform package, a Minsky moment regarding equity valuations, the shutdown of the US Federal government, a sudden surge in FX volatility or (god forbid) a nuclear strike emanating from North Korea. However, the onset of winter requires that one of these risks actually happens AND that the future probability of other bad things happening also increases.

The second part of this definition is more important that than the first. Without some form of contagion, investors’ response to one of these risks crystallising will likely resemble the current “buy-the-dip” consensus. The quickest way to understand this is a simple “what-if” exercise. Let us assume that US equities fall by 10% between now and the end of September. The trailing 52-week return declines from 13.4% to 3.1%, and realised volatility rises from 8% to about 10%, which is still well below the long-run average. The 52-week Sharpe ratio falls from 1.64 to 0.32, which is only just below the average for the last 10 years.

There is nothing very frightening in these numbers. We need a correction of 15% in US equities to drive the Sharpe ratio seriously below zero and even that would not be enough to shock them out of their low volatility regime – although the medium-term consequences might be. But this is precisely our point. We need two or more risk-scenarios to go wrong either simultaneously or very close together. Without contagion, the chances a cycle-ending bear market are really quite small.

Contagion also operates between countries, there needs to be a credible transmission mechanism and other markets need to be susceptible to infection. Based on current data, the US only has the 10th best 52-week Sharpe ratio in local currency terms. Other countries tend to have higher volatility but they also have higher running returns and their current rallies started later, so they don’t look as tired. Using the same 10% correction scenario for all countries, the US drops to #13 in our list of 25 major markets. The Eurozone and EM Equities as a whole would both have better risk-adjusted returns. So too would individual countries like Japan, Korea, China and Taiwan in NE Asia and France, Spain, Italy and the Netherlands.

In our view, global equity markets are likely to experience a correction this Autumn, but one snowstorm does not make a winter. Investors will survive it. It’s what happens afterwards that matters.

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