Protecting your Portfolio from different market environments – including tail risk hedging

Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or an ongoing and uninterrupted endowment.

 

The complexity and different approaches to providing portfolio protection (tail-risk hedging) has been highlighted by a recent twitter spat between Nassim Nicholas Taleb, author of Black Swan, and Cliff Asness, a pioneer in quant investing.

The differences in perspectives and approaches is very well captured by Bloomberg’s Aaron Brown article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

I provide a summary of the contrasting perspectives in the Table below as outlined by Brown’s article, who considers both men as his friends.

There are certainly some important learnings and insights in contrasting the different approaches.

 

PIMCO recently published an article Hedging for Different Market Scenarios. This provides another perspective.

PIMCO provide a brief summary of different strategies and their trade-offs in diversifying a Portfolio.

They outline four approaches to diversify the risk from investing in sharemarkets (equity risk).

In addition to tail risk hedging, the subject of the twitter spat above between Taleb and Asness, and outlined below, PIMCO consider three other strategies to increase portfolio diversification: Long-term Fixed Income securities (Bonds), managed futures, and alternative risk premia.

PIMCO provide the following Graph to illustrate the effectiveness of the different “hedging” strategies varies by market scenario.PIMCO_Hedging_for_Different_Market_Scenarios_1100_Chart1_58109

As PIMCO note “it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.”

As they emphasise “not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.”

A brief description of the diversifying strategies is provided below:

  • Long Bonds – holding long term (duration) high quality government bonds (e.g. US and NZ 10-year or long Government Bonds) have been effective when there are sudden declines in sharemarkets. They are less effective when interest rates are rising. (Although not covered in the PIMCO article, there are some questions as to their effectiveness in the future given extremely low interest rates currently.)
  • Managed Futures, or trend following strategies, have historically performed well when markets trend i.e. there is are consistent drawn-out decline in sharemarkets e.g. tech market bust of 2000-2001. These strategies work less well when markets are very volatile, short sharp movements up and down.
  • Alternative risk premia strategies have the potential to add value to a portfolio when sharemarkets are non-trending. Although they generally provide a return outcome independent of broad market movements they struggle to provide effective portfolio diversification benefits when there are major market disruptions. Alternative risk premia is an extension of Factor investing.
  • Tail risk hedging, is often explained as providing a higher degree of reliability at time of significant market declines, this is often at the expense of short-term returns i.e. there is a cost for market protection.

 

A key point from the PIMCO article is that not one strategy can be effective in all market environments.

Therefore, maintaining an array of diversification strategies is preferred “investors should “diversify their diversifiers””.

 

It is well accepted you cannot time markets and the best means to protect portfolios from large market declines is via a well-diversified portfolio, as outlined in this Kiwi Investor Blog Post found here, which coincidentally covers an AQR paper. (The business Cliff Asness is a Founding Partner.)

 

A summary of the key differences in perspectives and approaches between Taleb and Asness as outlined in Aaron Brown’s Bloomberg’s article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

My categorisations Asness Taleb
Defining a tail event Asness refers to the worst events in history for investors, such as the 5% worst one-month returns for the S&P 500 Index.

Research by AQR shows that steep declines that last three months or less do little or no damage to 10-year returns.

It is the long periods of mediocre returns, particularly three years or longer, that damages longer term performance.

Taleb defines “tail events” not by frequency of occurrence in the past, but by unexpectedness. (Black Swan)

Therefore, he is scathing of strategies designed to do well in past disasters, or based on models about likely future scenarios.

 

 

 

Different Emphasis

The emphasis is not only on surviving the tail event but to design portfolios that have the highest probability of generating acceptable long-term returns.   These portfolios will give an unpleasant experience during bad times.

 

Taleb prefers tail-risk hedges that deliver lots of cash in the worst times. Cash provides a more pleasant outcome and greater options at times of a crisis.

Investors are likely facing a host of challenges at the time of market crisis, both financial and nonfinancial, and cash is better.

Different approaches AQR strategies usually involve leverage and unlimited-loss derivatives.

 

Taleb believes this approach just adds new risks to a portfolio. The potential downsides are greater than the upside.
Costs AQR responds that Taleb’s preferred approaches are expensive that they don’t reduce risk.

Also, the more successful the strategy, the more expensive it becomes to implement, that you give up your gains over time e.g. put options on stocks

Taleb argues he has developed methods to deliver cash in crises that are cheap enough that they actually add to long-term returns while reducing risk.

 

 

Investor behaviours Asness argues that investors often adopt Taleb’s like strategies after a severe market decline. Therefore, they pay the high premiums as outlined above. Eventually, they get tire of the paying the premiums during the good times, exit the strategy, and therefore miss the payout on the next crash. Taleb emphasises the bad decisions investors make during a market crisis/panic, in contrast to AQR’s emphasis on bad decisions people make after the market crisis.

 

 

 

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Forecasted investment returns remain disappointing – despite recent market movements

Long-term expected returns from global sharemarkets have not materially changed despite recent sharemarket declines.

The longer term outlook for fixed income returns has deteriorated materially.

There is no doubt the investment environment is going to be challenging, not just in the months ahead, over the medium to longer term as well.

This should prompt some introspection as to the robustness of current portfolios.

From a risk management perspective an assessment should be undertaken to determine if current portfolio allocations are appropriate in meeting client investment objectives over the longer term.

A set and forget strategy does not look appropriate at this time. Serious thought should be given to where expected returns are going to come from over the medium to longer term.

By way of example, the expected long-term return from a traditional Balanced Portfolio, of 60% Equities and 40% Fixed Income, is going to be very challenging.

Arguably, the environment for the Balanced Portfolio has worsened, given return forecasts for fixed income and that they are not expected to provide the same level of portfolio diversification as displayed historically.

The strong performance of fixed income is a key contributing factor to the success of the Balanced Fund over the last 20 years. This portfolio plank has been severely weakened.

 

Asset Class expected forecasted Returns

A clue to future expected returns is outlined in the following Table generated by GMO, which they update on a regular basis.

The Table presents GMO’s 7-Year Asset Class Real Return Forecasts (after inflation of around 2%), as at 31 March 2020.

GMO 7-YEAR ASSET CLASS REAL RETURN FORECASTSGMO 7-Year Asset Class Real Return Forecasts March 2020

 

An indication of the impact of recent market performance on future market forecasts can be gained by comparing current asset class forecast returns to those undertaken previously.

The following Table compares GMO’s 7-Year Asset Class Real Returns as 31 March 2020 to those published for 31 December 2019.

The first column provides the 7-Year return forecasts updated as at 31 March 2020. These are compared to GMO’s return forecast at the beginning of the year.

The last column in the Table below outlines the change in asset class forecasted returns over the quarter.

31-Mar-20

31-Dec-19

Change

US Large

-1.5%

-4.9%

3.4%

US Small

1.4%

-2.2%

3.6%

International Equities

1.9%

-0.8%

2.7%

Emerging Markets

4.9%

3.5%

1.4%

US Fixed Income

-3.8%

-1.8%

-2.0%

International Fixed Income Hedged

-4.3%

-3.5%

-0.8%

Emerging Market Debt

3.0%

-0.6%

3.6%

US Cash

-0.2%

0.2%

-0.4%

       
US Balanced (60% Equities / 40% Fixed Income)

-2.4%

-3.7%

1.2%

International Balanced

-0.6%

-1.9%

1.3%

The following observations can be made from the Table above:

  • Although the return outcomes for equities have improved, they remain low, under 2% p.a. after inflation;
  • Emerging markets equities offer the most value amongst global sharemarkets, generally returns outside of the US are more attractive;
  • Expected returns from developed market fixed income markets have deteriorated, particularly for the US;
  • The expected outlook for Emerging Market debt has improved materially over the last three months; and
  • The return outlook for the Balanced Fund remains disappointing despite an improvement.

 

Impact of recent market movements on expected returns

The degree to which forecast sharemarket returns have increased may disappoint, particular given the extreme levels of market volatility experienced over the first quarter of 2020.

This in part reflects that global sharemarkets as a group “only” fell 11.5% over the first three months of the year. It probably felt like more.

Furthermore, although declining sharemarkets now translates to higher expected returns in the future, it is not a one for one relationship.

 

The relationship between current market performance and the impact on forecast returns is well captured by a recent Research Affiliates article.

As they note “When a market corrects dramatically, say, 30%, long-term expected returns do not rise by the same 30%.”

They illustrate this point using the US market (S&P 500 Index).

 

Research Affiliates estimate that a 30% pullback (drawdown) in the US sharemarket implies an increase in expected return of 1.7% a year for the next decade.

This is based on their assumptions for average real earnings per share over a rolling 10-year period for US companies and their estimate of fair value for the US sharemarket over the longer term. For an estimation of fair value they apply a cyclically adjusted price-to-earnings (CAPE) ratio.

The return estimate is based on the level and valuation of the US sharemarket on the 19th February, when the US market reached a historical high level (Peak).

The interrelationship between current market value, expected earnings, and the estimate of longer term value and their impact on expected returns is captured in the following diagram.

Based on market valuation, as measured by CAPE on 19th February 2020, the right-hand side displays the estimated change in expected returns from a decline in the US sharemarket from the peak in February e.g. a 30% drop in the S&P 500 Index from the Peak translates to a 1.7% change in Expected Return from valuation (change in CAPE).

The central point remains, a drop in the sharemarket today translates into higher expected returns.

Research Affiliates CAPE and Expected Return Estimates at Different Market Prices

The diagram above also captures the changing valuation of the market, as measured by CAPE, to a decline in the US sharemarket, as outlined on the left-hand side.

 

Research Affiliates long-term expected returns for a wide range of markets can be found on their homepage.

 

Caution in using Longer-term market forecasts

Forecasting the expected return for sharemarkets is extremely tricky, to say the least, with the likely variation in potential outcomes very widely dispersed.

Forecasting fixed income returns has a higher level of certainty.  The current level of interest rates provides a good indication of future returns. Given the dramatic fall in interest rates over the last three months, the expected returns from fixed income has deteriorated.

 

Nevertheless, caution should be taken when considering longer-term market forecasts.

This is emphasised in the Research Affiliates article, their “expected return forecasts also come with a warning label: Long-term expected returns, unto themselves, are not sufficient for short-term decision making. Ignoring this warning will most likely lead to impaired wealth.

Ten-year return forecasts offer valuable guidance to a buy-and-hold investor about the return they are likely to earn over the next decade. They provide no information, however, about when to buy or sell and do not identify a market top or bottom.”

 

Challenging Investment Environment

From a risk management perspective an assessment should be undertaken to determine if current portfolio allocations are appropriate in meeting client investment objectives over the longer term.

A set and forget strategy does not look appropriate at this time. Serious thought should be given to where expected returns are going to come from over the medium to longer term

There is no doubt the investment environment is going to be challenging, not just in the months ahead, over the medium to longer term as well.

 

This should prompt some introspection as to the robustness of current portfolios.

For example, the low expected return environment led GMO to declare earlier in the year it is time to move away from the Balanced Portfolio. The Balanced Portfolio is riskier than many people think.

The low expected return environment and reduced portfolio diversification benefits of fixed income is why the Balanced Fund is expected to underperform.

 

It is also partly driving institutional investors to develop more robust portfolios by investing outside of the traditional asset classes of equities and fixed income by increasing their allocations to alternative investments.

As highlighted by a recent CAIA survey investments into alternatives, such as private equity, real assets, and liquid alternatives, are set to grow over the next five years, becoming a bigger proportion of the global investment universe.

 

Research by AQR highlights that diversifying outside of the traditional asset is the best way to manage through severe sharemarket declines. Furthermore, diversification should work in good and bad times

 

For those interested, posts on the optimal private equity allocation and characteristics and portfolio benefits of real assets may be of interest.  Real assets offer real portfolio diversification benefits, particularly in different economic environments.

My Post Investing in a Challenging Investment Environment outlines suggested changes to current investment approaches that could be considered.

 

Good luck, stay healthy and safe.

 

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

What too expect, navigating the current Bear Market

After reaching a historical high on 19th February the US sharemarket, as measured by the S&P 500 Index, recorded:

  • Its fastest correction from a peak, a fall of 10% but less than 19%, taking just 6 days; and
  • Its quickest period to fall into a Bear market, a fall of greater than 20%, 21 days.

The S&P 500 entered Bear market territory on March 12th, when the market fell 9.5%, the largest daily drop since Black Monday in October 1987.

The 21 day plunge from 19th February’s historical high was half the time of the previous record set in 1929.

S&P500

Source: ETF.com

This follows the longest Bull market in history, which is a run up in the market without incurring a 20% or more fall in value. The last Bear market occurred in 2008 during the Global Financial Crisis (GFC).

The 11-year bull market grew in tandem with one of the longest economic expansions in US history, this too now looks under threat with a recession in the US now looking likely over the first half of 2020. Certainly, global recession appears most likely.

 

Global sharemarkets around the world have suffered similar declines, some have suffered greater declines, particularly across Europe.

Markets lost their complacency mid-late February on the spreading of the coronavirus from China to the rest of the world and after Chinese manufacturing data that was not only way below expectations but was also the worst on record.

A crash in the oil price, which slumped more than 30%, added to market anxieties.

 

Extreme Volatility

The recent period has been one of extreme market volatility, not just in sharemarkets, but currencies, fixed income, and commodity markets.

As the Table, courtesy of Bianco Research, below highlights, three of the five days in the week beginning 9th March are amongst the 20 biggest daily gains and losses.

After the 9.5% decline on 12th March, the market rebounded 9.3% the following day. The 7.6% decline on the 9th March was, to date, the 20th largest decline recorded by the S&P 500.

2020 is joining an infamous group of years, which include 1929, 1987, and 2008.

Extreme volatility

Where do we go from here?

Great question, and I wish I knew.

For guidance, this research paper by Goldman Sachs (GS) is helpful: Bear Essentials: a guide to navigating a bear market

To get a sense as to how much markets are likely to fall, and for how long, they look at the long-term history of the US sharemarket. They also categories Bear markets into three types, reflecting that Bear markets have different triggers and characteristics.

The three types as defined by GS are:

  • Structural bear market – triggered by structural imbalances and financial bubbles. Very often there is a ‘price’ shock such as deflation that follows.
  • Cyclical bear markets – typically a function of rising interest rates, impending recessions and falls in profits. They are a function of the economic cycle.
  • Event-driven bear markets – triggered by a one-off ‘shock’ that does not lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation).

They then plot US Bear Markets and Recoveries since the 1800s, as outlined in the following Table:

Historical US Bear markets

Source: Goldman Sachs

From this they can characterise the historical averages of the three types of Bear markets, as outlined at the bottom of the Table:

GS summarise:

  • Structural bear markets on average see falls of 57%, last 42 months and take 111 months to get back to starting point in nominal terms (134 months in real terms (after inflation)).
  • Cyclical bear markets on average see falls of 31%, last 27 months and take 50 months to get back to starting point in nominal terms (73 months in real terms).
  • Event-driven bear markets on average see falls of 29%, last 9 months and recover within 15 months in nominal terms (71 months in real terms).

 

In their opinion GS currently think we are in an Event-driven Bear market. Generally these Bear markets are less severe, but the speed of the fall in markets is quicker, as is the recover. However, as they note none of the previous Event-Driven Bear markets were triggered by the outbreak of a Virus, nor were interest rates so low at the start of the market decline.

Therefore, they conclude, a fall of between 20-25% can be expected, and the rebound will be swift.

This makes for an interest couple of quarters, in which the economic data and company profit announcements are sure to get worse, yet equity markets will likely look through this for evidence of a recovery in economic activity over the second half of this year.

 

Happy investing.

 

Please read my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

Recessions, inverted yield curves, and Sharemarket returns

Fears of economic recession, particularly in the US, peaked over the final three months of 2018.

Nevertheless, talk of economic recession has now faded into the background after the US Federal Reserve hit the pause button to further interest rate increases in January of 2019. The Fed is not expected to raise interest rates again in 2019.

This is not to say that a recession will not occur, it will at some stage, just as night follows day. The economic/business cycle has not been conquered.

Nevertheless, the timing of the next recession is unknown. Take Australia for example, their last recession was over 28 years ago. New Zealand is over 9 years since their last recession.

With regards to the US, in July of this year the US economy will enter its longest period in history without incurring a recession. Their economy remains on a sound footing: interest rates remain low, the US consumer is confident, businesses are investing, the Government is increasing spending, and forward looking indicators of economic activity remain positive. Lastly, housing activity is likely to pick up over the second half of 2019.

 

What is a Recession?

A recession is defined as at least two consecutive quarters of declining economic growth. The US National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales.”

 

A recent article by the Capital Group: Preparing for the next recession: 9 things you need to know provides a good overview of the ins-and-outs of economic recession.

 

The good news, as Capital highlight, recessions generally aren’t very long.

Capital undertook analysis of 10 US economic cycles since 1950. This analysis showed that recessions have lasted between eight and 18 months, with the average spanning about 11 months. Unfortunately New Zealand’s history is a little more chequered than the US.

Investors with a long-term investment horizon, should expect to experience a number recession over their investment horizon and therefore look through the full economic cycle. Fortunately, for most of us, we spend more time in economic expansion than in recession.

Capital note, “over the last 65 years, the U.S. has been in an official recession less than 15% of all months.”

The following graph highlights the average length, total growth, and returns from the average stock market return over the average recession and economic expansion.

Notably, “equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.”

The human cost of economic recession is provided in the form of jobs lost and this should not be forgotten.

 

Economic cycles Capital.jpg

 

From a sharemarket perspective, a bear market, defined as a 20% or more fall in value, usually overlaps with recessions.

Share markets tend to lead the economic cycle, given they are forward looking. Sharemarkets on average peak six months prior to the onset of a recession. They continue to fall during the early stages of a recession.

The recovery in sharemarkets often takes hold while the economy is still in recession (economic growth is still contracting).

The initial bounce in sharemarkets is often a period of strong performance and occurs before there is any hard evidence of a pickup in economic activity.

The following graph presents the above sequencing and overlapping nature of sharemarket returns and recessions.

Sharemarket returns and recession cycles.png

 

Having said all that, stock markets are not good predictors of economic recession i.e. a sharp fall in global sharemarket does not mean there will be an onset of global economic recession.

This is captured by the well know quote from Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

 

Sharemarket Returns and Inverted Yield Curves

There has been a lot of discussion over the last twelve months about the implications of an inverted US yield curve. (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months). A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Parts of the US yield curve are currently inverted, and this inversion has increased over recent days.

The significance of this is that prior to the last 7 US recessions the yield curve has inverted prior each time. An inverted yield curve has by and large been a good predictor of recession.

Nevertheless, not every time the yield curve inverts does a recession follow and on average the inversion of the yield curve occurs 12 months prior to a recession.

 

The following analysis undertaken by Wellington Management looks at the performance of the US sharemarket in relation to yield curves inversions.

The period of analysis is from the 1950s at which time the US Federal Reserve gained full, independent control over interest rates from the US Treasury. As Wellington note, “it was after this transition that the yield curve became an effective tool for gauging the impact of monetary policy on the economy and the prospect of a recession.”

Wellington present the following analysis and the Table below:

  • “As shown in the third column (of Table below), the S&P 500 peaked ahead of a yield-curve inversion only twice (1959 and 1973).
  • “The median time between inversion and peak equity returns was 17 months, and in several cases the market peaked almost two years or more after inversion.”
  • “Aggregate equity returns post-inversion have been partly dependent on the length of time between the initial inversion and the start of the recession.”
  • “Since returns tend to be negative right around the time a recession begins, the instances in which there was a shorter period between the initial inversion and the start of the recession were more likely to have a negative return.”

 

Just like there is a period of time between economic recession and an inverted yield curve, the sharemarket often peaks after the yield curves inverts.

Sharemarket returns and inverted yield curves.png

 

Back to the Capital article, for it also runs through a number of other recession related questions.

Of interest are:

What economic indicators can warn of a recession?

  • Capital outline some generally reliable signals worth watching closely, such as an inverted yield curve, corporate profits, unemployment, and leading economic indices.
  • Importantly it is appropriate to look at and consider several different economic indicators.

 

What Causes Recessions?

  • There are many reasons for a recession, chief amongst them are rising interest rates, particularly by Central Banks such as the US Federal Reserve and Reserve Bank of New Zealand, imbalances within an economy e.g. excess housing prices, high debt levels
  • Every economic cycle is unique, but anything that impacts on corporate profits or consumer spending, such as rising unemployment, are factors to consider.

 

Just remember is it notoriously difficult to predict economic recession and they are normally the result of a number of factors that have a cascading effect leading to an economic downturn.

 

The following Kiwi Investor Blog Posts maybe of interest to those wanting a better understanding of inverted yield curves, leading economic indicators, and historical performance of equity market corrections.

Recession predictability of inverted yield curves and other economic indicators to considered:

 

Analysis of Sharemarket corrections and market declines

 

Lastly the Capital article provides some suggestions as to how to position your portfolio for a recession. I think it is exceedingly difficult to finesse a portfolio in the expectations of a recession.

From my perspective, the following is most critical:

  • Maintain a long-term perspective;
  • Implement a balanced and broadly diversified portfolio. Portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration (movements in interest rate), economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks;
  • Know you risk tolerance: what level of volatility in capital are you prepared to handle without changing your mind;
  • Understand your risk capacity: the amount of risk you need to take in order to reach your financial goals;
  • Implement a goals-based investment approach, where success is measured on how you are tracking relative to your investment goals, rather than market index performances; and
  • Always maintain a high quality portfolio, with plenty of liquidity, and limit the level of turnover across the portfolio e.g. amount of trading (buying and selling)

 

A good advisor should be able to help you with the above and see you through bouts of sharemarket volatility, including a recession environment.

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

cropped-title-picture-enhanced.jpg

2018 was a shocking Year

Well its official, 2018 was a shocking year in which to make money. Not for some time, 1972, has so many asset classes failed to deliver 5% or more in value.

In terms of absolute loses, e.g. Global Financial Crisis (GFC 2007/08), investors have incurred far worst returns than 2018, nevertheless, as far as breadth of asset classes failing to deliver upside returns, 2018 is historical.

 

Here is a run through the numbers:

International Equities were down around 7.4% in local currency terms in 2018:

  • The US was one of the “better” performing markets, yet despite reaching historical highs in January and then again in September, had its worst year since the GFC, December was is its worst December return outcome since the 1930s.
  • The US market entered 2018 on a record run, experiencing it longest period in history without incurring a 5% or more fall in value.  This was abruptly ended in February.
  • During the year the US market reached its longest period in history without incurring a Bear market, defined as a fall in value of more than 20%. Albeit, it has come very close to ending this record in recent months.
  • Elsewhere, many global equity markets are down over 20% from their 2018 peaks and almost all are down over 10%.
  • Markets across Europe and Japan fell by over 12% – 14% in 2018
  • The US outperformed the rest of the world given its better economic performance.
  • The New Zealand sharemarket outperformed, up 4.9%!

Commodities, as measured by the Bloomberg Index, fell over 2018. Oil had its first negative year since 2015, falling 20% in November from 4 year highs reached in October. Even Gold fell in value.

Hedge Fund indices delivered negative returns.

Global credit indices also delivered negative returns, as did High Yield

Emerging Market equities where negative, underperforming developed markets.

Global listed Property and Infrastructure indices also returned negative returns.

Fixed Interest was more mixed, Global Market Indices returned around 1.7%:

  • US fixed interest delivered negative returns for the year, as did US Inflation Protected fixed interest securities. US Longer-term securities underperformed shorter-term securities.
  • NZ fixed interest managed around +4.7% for the year.

The US dollar was stronger over 2018, this provided some relief for those investing outside of their home currency and maintained a low level of currency hedging.

The above analysis does not include the unlisted asset classes such as Private Equity, Unlisted Infrastructure, and Direct Property investments.

 

Two last points:

  • Balance Bear, under normal circumstances, fixed interest, particularly longer-term securities, would perform strongly when equity markets deliver such negative returns as experienced in 2018. This certainly occurred over the last quarter of 2018 when concerns over the outlook for global economic growth became a key driver of market performance. Nevertheless, over the year, fixed interest has failed to provide the usual diversification benefits to a Balanced Portfolio (60% Equities and 40% Fixed Income). Many Balanced Portfolios around the world delivered negative returns in 2018 and failed to beat Cash.
  • Volatility has increased. Research by Goldman Sachs highlights this. In 2018 the US S&P 500 Index experienced 110 days of 1%+ movements in value, this compares to only 10 days in 2017.

 

Happy investing.

 

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Recent Market volatility and end of year market and economic forecasts

There are lots of economic and market forecasts at this time of the year. Many are easily accessed on the internet.

Does anyone care about these forecasts? Or do we place too much emphasis on these forecast? These topics are covered in a recent Institutional Investor article. Some good points are made.

 

The current market volatility is likely to be front of mind presently for many investors. Others may be seeing it as an opportunity.  What ever your view of 2019, a longer term perspective should always be maintained.

Either way, it has been a tough year to make money .

 

Most likely, your view of the current market volatility is closely tied to your forecast for 2019.

On this note, there are number of reasons to be “relaxed” about the current market volatility as outlined in the recent Think Advisor article.

 

Why should we be relaxed about the current bout of volatility? The most pertinent reasons from the article are as follows:

The US economy is still strong

US Economic growth accelerated in 2018 while the rest of world slowed. Global growth is expected to moderate in 2019 from the current pace in 2018.

Albeit, the US economy is still strong with unemployment at its lowest level since 1969, consumer and business confidence remains healthy, forward looking indicators are supportive of ongoing economic growth.

Although growth is slowing in Europe and China the environment remains supportive of ongoing economic expansion.

Global sharemarkets appear to have already adjusted for a more moderate level of global economic growth in 2019.

 

Stock Fundamentals are okay

Global corporate earnings are forecast grow over the next twelve months, supported by the economic backdrop outlined above.

As alluded to above, value has appeared in many global markets given recent declines.

 

Yield curve inversion

Markets are pre-occupied with the possibility of a US inverted yield curve. This appears overdone. Yield curve Inversion is when the yield (rate of interest) is lower on longer dated fixed interest securities compared to shorter dated securities. Under normal circumstance longer dated securities have a higher yield than shorter dated securities.

As highlighted previously  an inverted yield curve is a necessary but not sufficient pre-condition to recession. Not every yield curve inversion is followed by a recession .

There is also a considerable time lag between yield curve inversion and economic recession. A period of time in which sharemarkets have on average performed strongly.

Lastly, the traditional measure of yield curve inversion, 3 month yield vs 10 year yield, is not inverted!

 

Of the reasons provided in the article, the above are the most relevant and worthy of taking note of.

Nevertheless, global trade is a key source of the current market volatility and is likely to remain so for sometime.  Likewise it may take time for markets to gain comfort that global economic growth has stabilised at a lower rate of expansion. Therefore, continued market volatility is likely.

Alternatively, a pause in the US Federal Reserve raising short term interest rates would also likely provide a boost to global sharemarkets.

 

PIMCO, as recently reported, highlight that the risk of a recession in the US has climbed in 2019.

This prediction is made in the context that the US is nearing a decade long period of economic expansion, the longest period in its history without experiencing an economic recession (defined as two consecutive quarters of negative economic growth).

PIMCO note “The probability of a U.S. recession over the next 12 months has risen to about 30 percent recently and is thus higher than at any point in this nine-year-old expansion, Even so, the models are flashing orange rather than red.”

“The last few months have given us a sense of the types of risks that are out there, that both the economy and markets are going to face in 2019,” ….. “At a minimum, like we have seen this year, expect ongoing volatility and that’s true across all segments of the financial markets.”

 

Happy investing.

 

Please see my Disclosure Statement

  

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Balanced Bear Market

A “Balanced Bear” is when both equities and bonds sell off together.

As a result, a Balanced Fund, 60% invested in the stockmarket (equities) and 40% invested in fixed income (bonds), has a larger than normally expected period of underperformance – a Balanced Fund Bear Market.

During these periods the diversification benefits of bonds relative to equities disappears.

As you will know, historically if the stock market is selling off sharply, money is moving into fixed income. This drives up the price of fixed income securities helping to partially offset the negative returns from the stock market.  A Balance Fund can come through these periods of equity market uncertainty relatively unscathed.

In a Balance Bear, equities are falling in value and fixed income is also falling in value given interest rates are rising (noting as interest rates rise the price, and therefore value, of a fixed income security falls).

This type of market environment was evident in early 2018 and was a prominent feature of the market volatility in early October 2018.

 

The thesis of the Balanced Bear has been promoted by Goldman Sachs and their equity analyst Christian Mueller-Glissmann raised the idea on CNBC in February of this year.

Goldman Sachs have written extensively on the Balance bear using historical US financial market data.

Importantly, a Balanced Fund is now into its longest period of outperformance, reflecting the very strong record run in US equities since 2009 and that interest rates, albeit they have risen from their June 2016 lows, are still at historical lows and have provided solid returns over the longer time frames.  The same can be said about New Zealand “Balanced Funds”.

 

The Anatomy of equity bear markets is well documented, not so for a Balanced Fund bear market.

In this regards Goldman Sachs (GS) has undertaken a wealth of analysis.

 

Requirements for a Balanced Bear – usually a Balance Bear requires a material economic growth or inflation shock.

In this regard, the largest Balance Fund declines over the last 100 years have been in or around US recessions (economic growth shock).

Nevertheless, Goldman Sachs also found that the Balance Fund can have long periods of low real returns (i.e. after inflation) without a recession e.g. mid 40s and late 70s. These periods are associated with accelerating inflation.

 

Naturally, equities dominate the risk within a Balanced Fund, therefore large equity market declines e.g. Black Monday 1987 are associated with periods of underperformance of Balanced Funds.

Not surprisingly, most of the largest Balanced Fund falls in value have been during US recessions, but not all e.g. 1994 Bond market bubble collapsing, stagflation of 1970 (low economic growth and high inflation), 1970’s oil shock.  It is worth noting that the 1987 sharemarket crash was not associated with a US recession.

 

Also of note, the stagflation periods of the 1970’’s and 80’s are periods in which there were large falls in both equities and bonds.

 

Bond market bears – are usually triggered by Central Banks, such as the US Federal Reserve, raising short term interest rates in response to strong growth and an overheating of the economy.  Bond market bears have been less common in modern history given the introduction of inflation targets anchoring inflation expectations.

 

Equity markets can absorb rising interest rates up to the point that higher interest rates are beginning to restrict economic activity. An unanticipated increase in interest rates is negative for sharemarkets and will lead to higher levels of volatility e.g. 1994 or recent tapper tantrum of May 2013.

 

As noted in previous blogs, most equity bear markets have been during recessions…but not all.

Goldman Sachs makes this point as well, noting the majority of 60/40 drawdowns of more than 10% have been due to equity bear markets, often around recessions. They note it is very seldom the case that equities deliver positive returns during a 60/40 drawdown (they estimate only in c.5% of cases).

With regards to recessions, Goldman Sachs note that there have been 22 recessions since 1900 and 22 S&P 500 bear markets. However, not every bear market automatically coincided with a recession in the last 100 years – out of the 22 since 1900, 15 were around a recession – 7 due to other factors.

 

Also, high equity valuations don’t signal a bear market. Nevertheless, they do signal below average returns over the medium to longer term. Albeit, sharemarket bear markets are not associated with low valuations!

 

Therefore, assessing the risk of a US recession is critical at this juncture.  As covered in a recent Post the “warning signs” of recession are not present currently based on a number of US Recession warning indicators.

 

Lastly, as also noted in a previous Post it is very difficult to predict bear markets and the costs of trying to time markets is very expensive.  The maintenance of a truly diversified portfolio and portfolio tilting will likely deliver superior return outcomes over the longer term.

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

It is a good time to reflect on the diversification of your portfolio at this time in the market cycle. As Goldman Sachs note, both equities and bonds appear expensive relative to the last 100 years.

In a Balanced Bear scenario there are very few places to hide.

  

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

US Recession Warning Indicators

As you will know the US economy is into its second longest period of economic expansion which commenced in June 2009.

Should the US economy continue to perform until July 2019, which appears likely, the US will enter its longest period of economic expansion. The longest expansion was 10 years, occurring during the tech expansion of the 1990s, the current expansion is nine years.

Similarly, the US sharemarket is into its longest bull market run, having not experienced a drop-in value of greater than 20% (bear market) since March 2009.

As a rule, sharemarkets generally enter bear markets in the event of a recession.

 

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

Since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

 

Statistically:

  • The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  • The average Bear Market period lasted 1.3 years with an average loss of -41
  • Historically, and on average, equity markets tend not to peak until six – twelve months before the start of a recession.

 

Therefore, let’s look at some of the Recession indicators.

In a recent article by Brandywine, they ran through some of the key indicators for a US recession.

Federal Reserve Bank of Atlanta’s GDP Nowcast.

This measure is forecasting annualised economic growth of 4.4% in the third quarter of 2018. This follows actual annualised growth of 4.2% in the second quarter of 2018.

Actual US economic data is strong currently. Based on the following list:

  • US unemployment is 3.7%, its lowest since 1969
  • Consumer Confidence is at an 18 year high
  • US wages are growing at around 3%, the savings rate is close to 6%, leaving plenty of room for consumers to increase spending
  • Small business confidence is at all-time highs
  • Manufacturing and non-manufacturing surveys are at their best levels for some time (cycle highs)

 

Leading Indicators

The Conference Board’s Index of Leading Indicators, an index of 10 components that includes the likes of the ISM New Order Index, building permits, stock prices, and the Treasury yield curve.

The Conference Board’s Index is supportive of ongoing economic activity in the US.

 

Yield Curve

The shape of the yield curve, which is normally upward sloping, meaning longer term interest rates are higher than short term interest rates, has come in for close attention over the last six months. I wrote a about the prospect of a negative yield curve earlier in the year.

An inverted yield curve, where shorter term interest rates (e.g. 2 years) are higher than longer term interest rates (e.g. 10 years) has a pretty good record in predicting a recession, in 18 months’ time on average.

With the recent rise of longer dated interest rates the prospect of an inverted yield curve now looks less likely.

Albeit, with the US Federal Reserve is likely to raise short term interest rates again this year and another 3-4 times next year the shape of the yield curve requires on going monitoring.

Having said that, an inverted yield curve alone is not sufficient as a predictor of economic recession and needs to be considered in conjunction with a number of other factors.

 

Brandywine conclude, “what does a review of some well-known recession indicators tell us about the current—and future—state of the U.S. expansion? The information provided by the indicators is mixed, but favors the continuation of the current expansion. The leading indicators are telling us the economy should continue to expand well into next year—at least.”

In favour of ongoing economic expansion is low unemployment, rising wages, simulative financial conditions (e.g. low interest rates are supportive of ongoing growth, as are high equity prices), high savings rate of consumer and their low levels of debt. Lastly government spending and solid corporate profitability is supportive of economic activity over the medium term.

As a word of caution, ongoing US – China trade dispute could derail global growth. Other factors to consider are higher interest rates in combination with a higher oil price.

Noting, Equity markets generally don’t contract until interest rates have gone into restrictive territory. This also appears some time away but is a key factor to monitor.

Lastly, a combination of higher oil prices and higher interest rates is negative for economic growth.

 

I have used on average a lot in this Post, just remember: “A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

How long will the record US equities bull market run continue for?

An interesting view from JP Morgan.

The US Equity market is within a month of recording its longest ever bull market.  Many are expecting it to continue well into 2019.  The US economy will reaches its longest period of economic expansion in modern history July 2019.

History of Sharemarket corrections – An Anatomy of equity market corrections

 

JP Morgan view.

www.bloomberg.com/news/articles/2018-07-19/jpmorgan-says-record-breaking-bull-market-could-run-until-2020

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Risk of Economic Recession and an Inverted Yield Curve

There has been a lot of discussion recently about the prospect of an inverted US yield curve.  (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months).  A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Historically an inverted yield curve is a powerful recession sign.  John Williams, who will take over the helm of the New York Federal Reserve Bank of New York in June, said earlier in the year a truly inverted yield curve “is a powerful signal of recessions” that has historically occurred (italics is mine).

The US yield curve spread (difference in yield) between the 2 year and 10 year US Treasury interest rates has recently reached its narrowest in over a decade.  Thus the heightened discussion.

As can be seen in the graph below the US Treasury yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.

It should be noted that the US yield curve has not yet inverted and there is a lag between inversion and recession, on average of 1 to 2 years.  See graph below.  I am not sure I’d call the Yield Curve still “Bullish” all the same.

At the same time, the risk of recession does not currently appear to be a clear and present danger.

Much of the flattening of the current yield curve (i.e. shorter-term interest rates are close to longer-term interest rates) reflects that the US Federal Reserve has increased shorter-term interest rates by over 150 bpts over the last 2 years and longer-term interest rates remain depressed largely due to technical factors.  Albeit, the US 10 year Treasury bond recently trade above 3%, the first time since the start of 2014.  Therefore, the current shape of the US yield curve does make some sense.

Inverted yield curve.png

 

The picking of recession is obviously critical in determining the likely future performance of the sharemarket.

As a rule, sharemarkets generally enter bear markets, falls of greater than 20%, in the event of a recession.

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

See the graph below, as it notes, since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

bear market recessions.jpg

 

Statistically:

  1. The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  2. The average Bear Market period lasted 1.3 years with an average loss of -41%
  3. Historically, and on average, equity markets tend not to peak until six months before the start of a recession.

The current US sharemarket bull market passed its 9 year anniversary in March 2018.  The accumulated return is over 300%.

 

Mind you, we have to be careful with averages, I like this quote:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

Assessing Recession Risk

Importantly, investors should not use the shape of the yield curve as a sole guide as to the likelihood of a recession.

The key forward looking indicators to monitor include an inverted yield curve, but also a significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders.

Tightening of financial conditions is also a key indicator, particularly central banks raising interest rates (or reducing the size of their balance sheet as in the current environment) e.g. US Federal Reserve, but also tightening of lending conditions by the large lenders such as the commercial banks to consumers and more particularly businesses.

Lastly, equity market valuation is important.

Happy investing.

 

Please see my Disclosure Statement