Investors have profited from allocating to passive funds and seeing both bonds and equities rise in an extended low volatility environment but there is currently too much complacency in the market and too much of myopic short-termism. That is the prevailing view of Michael Ho, Senior Managing Director of SSgA and Chief Investment Officer for Active Emerging Market Equities and global macro strategies.
Ho points to two main lessons that investors have had to learn in 2014.
The first relates to the widespread consensus at the start of the year among brokerage houses and economists that the US 10-year Treasury yield would rise to 3.5 percent by the end of the year. In fact, the opposite has happened. At the time of writing, the US 10-year is yielding 2.35 per cent1.
“This year, rates continued to decline aside from some gyrations in emerging markets. This goes to show that following the consensus may not be the best thing to do. In fact, when they forecast the future most people get it wrong, particularly the immediate future,” said Ho. “It’s important to focus on the long term when it comes to investing.”
At SSgA, Ho and his team believe that a premia-free 10-year Treasury should be yielding close to 2.7 per cent; some way off the 3.5 per cent forecast in the beginning of the year. As such, the team opened the year, long treasuries and has traded around this view through the year. Writing in his latest edition of “An Alternatives View”, Ho states that the 2.7 per cent fair yield “affirms our disagreement with the majority of forecasts that were calling for an imminent long-maturity bond yield rise”.
Second, short volatility positions in the market earlier this year provided another lesson on market short-sightedness. In one prevailing strategy, investors sold options to collect a premium (or carry), banking on market volatility remaining subdued. But in Ho’s opinion, that’s a hazardous strategy; taking that tail risk can lead to double-digit performance declines over the course of just one month. Indeed, when volatility upticked in September and October, investors took losses when unwinding short volatility positions.
“That strategy suffered a huge decline in returns in Sep and Oct and people switched out of that position into a long volatility position, buying options. The fact is when you look at the overall aggregate market, including retail and hedge funds, there are a lot of people selling options hoping to collect the premia but that’s very dangerous.
In 2014, markets have focused on central bank activity in two key regions: the eurozone and Japan, according to Ho. The ECB has made it very clear that it needs to continue quantitative easing due to disinflationary trends in the eurozone. This deflation grew out of the deleveraging of banks’ balance sheets in 2013.
With respect to Japan, Ho says that all eyes are on the central bank’s quantitative and qualitative monetary easing programs (QQE).
“It is clear that Abenomics is questionable. We know that this is really the last straw. In order to make it work Japan needs to monetise its debt. There are obvious implications to doing that. The currency markets have already reacted and we’ve seen a sharp deterioration of the yen; a trade that has also worked well for us. However, the next question is what will happen to the assets, in particular JGBs? This is not yet clear.”
Risk parity in rising volatility markets
Risk parity – a strategy to take long positions in both equities and bonds based on their negative correlation – has long been a popular trade for investors, including global macro. On a risk-adjusted basis in balanced portfolios, risk parity has been effective over the past 15 years, driven in large part by consistently falling interest rates and declining inflation. Between 2000 and 2003, when equities fell significantly, bonds rallied. The negative correlation between the two asset classes acted as a useful hedge for pension fund assets.
Ho points out that his worry is not whether interest rates will go up, but that the negative correlation of stocks and bonds, which has long helped to create diversification benefits in investor portfolios, will start to shift towards a positive correlation.
“If this negative correlation reverses, the market will experience a lot more volatility. We may see a return to the market conditions of the 1970s where the correlation between stocks and bonds are more positive. It means that whenever there’s a shock to discount rates, or to interest rates, both equities and bonds may react in the same way instead of moving in opposite directions. A sharp rise in the discount rate, whatever the reason may be, will lead to a fall in both equities and bonds,” says Ho.
This correlation switch may happen when the real rate of interest starts to rise. At SSgA, the anticipation is that this will start to happen in the U.S., possibly middle of next year, as the Fed looks to increase short-term interest rates. After all, the U.S. economy is improving, growth is starting to come back, the housing sector is starting to recover; all important signs.
The conclusion for investors is that the moment global real rates start to increase – accompanied by US growth that will boost equity markets — the existing negative correlation between stocks and bonds would start to reverse. The resulting increase in volatility is something that today’s investors overlook. Case in point, the VIX Index level has hit multi-year lows this year and fixed income volatility remains muted. So in Ho’s opinion, the market is overly focused on what’s happening now.
“Given the low volatility and the high carry you can get by selling options, it seems everyone wants to be in this trade. But that’s a risky strategy in an environment where the real rate might start to experience an uptick globally,” says Ho.
High-volatility events – like those in September and October of this year – might occur at an even higher magnitude in 2015, according to Ho. Therefore, given today’s low yields and the influence of volatility on the Sharpe Ratio, investors need to take a multi-faceted approach that considers yields, volatility and the risk premia.
The end of buy and hold
Speak to any hedge fund manager and they welcome volatility in the markets; that’s what gives them their edge and allows them to make strategic calls. So central bank intervention that has stripped volatility from the markets has actually been a challenge for hedge fund managers over the last five years. Quantitative Easing programs have effectively acted as artificial life support to developed economies.
Take the S&P 500. Since March 2009 it has grown 200 percent, and it has had a Sharpe Ratio greater than 1 for the last two years. As such, passive funds have become far more popular as investors opt for lower costs. On the other hand, active funds have seen significant ouflows. But the good news – for hedge fund managers anyway – is that the low risk, high return environment in US equities is unlikely to continue. In Ho’s opinion, correlation across asset classes and securities will decrease, and markets will return to a more normalised environment where active managers can again excel at generating alpha.
Additionally, as volatility picks up, markets could see the collapse of the carry trade. With interest rates low, investors have been seeking carry trades across high yield, master limited partnerships, real estate, or even in dividend-yielding stocks as a way to generate income. If real rates in the US and emerging markets start to rise, the carry trade may become less of a draw for investors.
Ho says that he sees significant opportunities in currency markets, and in the relative pricing between Japanese or European assets, versus the rest of the world.
If volatility does return to the markets and rates rise, it will once again favour active managers able to take a more tactical, alpha-driven approach to generating outsized returns. Opportunities to do this have been severely curtailed over the last few years.
Ho remains negative on emerging markets, partly due to a rapidly increasing credit creation in the last five years in China. BIS data on non-financial private sector credit shows that since 2008, credit creation has primarily come from emerging markets, in particular China. Indeed, Chinese credit has risen to roughly 1.5x GDP2 in only a few years.
“The speed at which you create credit is tied to the financial crisis,” says Ho. “What’s likely to happen is that the growth in GDP driven by excessive investment and inefficient allocation of resources in China will likely slow down. It’s already starting and will likely continue for at least five years.”
That said, there are pockets of opportunity in emerging markets such as Russia. Ho believes if there is a recovery in oil price this should lead to a recovery in Russian equities and therefore the rouble. Russia is difficult because it is fraught with political risk but as Ho points out, it is decoupled from the rest of the emerging markets.
The End of the “Goldilocks” Era
Passive investors are currently enjoying a “Goldilocks” era in the economy: where growth is not too high to instigate major tightening monetary policies, not too low to prompt recessionary concerns, but “just right” for carry trades, short-volatility strategies, and long-beta positioning.
Pension fund CIO’s are now starting to think about the next two years; they wonder how and if global macro strategies can play a role.
Passive funds have had high returns in recent months, but importantly, Ho advises that this is not likely to continue. Investors should start reassessing allocations to best position for higher volatility.
“Now, investors have an opportunity to start becoming more tactical. That’s why global macro strategies will be an interesting diversifier in our view,” says Ho.
1 Bloomberg
2 BIS, Bloomberg, SSGA
