Wednesday, December 12, 2018

Yield Curve Impact on Asset Prices - Evidence Does Not Provide Simple Answers



Let's just make things clear. There have not been many yield curve inversions, so analysts who want to study the behavior of asset prices during inversions have limited data. Yield curves may signal recessions which may also signal a decline in equities associated with slower growth, but the timing links are highly variable. The risk differs depending on how the question is asked.

The relationship between the yield curve and equity prices is not easy to unravel.  Yield curve inversion may signal tighter monetary policy that affects credit availability which leads to a decline in equity prices. The impact can be affected by whether rates are rising or falling. It is can be affected by the valuation in equities. 

The answer on return impact can be affected by whether you are looking at current or forward returns. There is no single answer and much of the work has not been rigorously tested; however, there is enough research to make some judgments. 

Our main takeaways are:
  • Flat and inverted curves can be good for curve steepening trades.
  • The worst yield curve environment for equities is bull steepening 
  • Flat curve periods can still see positive equity returns. 
  • Equity returns during the period between inversion and recession have been positive. The average period between inversion and recession is 17 months. 
  • Valuation still is an important driver of future returns regardless of the yield curve.
  • There is a long but variable lag between a yield curve inversion and the start of an equity correction.


Evidence:

The PIMCO table suggests that fixed income investors don't have to worry. Flattening and inverted are good returns periods. Those steep curves are when you have to worry. This mixes cause and effect. Steep curves means we are likely in a recession and monetary policy is being used to help the economy. Flat and inverted curves mean that we are late in the business cycle. Better for fixed income.
From BMO, equities can do well in a flat yield curve environment.

From BlackRock, the worst equity returns are during a bull steepening period.


From LPL, the period between inversion and recession is associated with positive equity gains.

From The BAM Alliance, looking through the inversion, investors will be rewarded with positive returns; however, the impact will be related to the valuation at the time of the inversion. 



From Ritholtz Wealth Management, returns are generally positive for the period between inversion and recession. There is a long lag between inversion and the start of the correction, but the lag period is highly variable.


Tuesday, December 11, 2018

Central Bankers as a Tribe of Technocrats - Outside the Mainstream?


Are you a technocrats or a politician? If you listen to central banks, they will say they are just technocrats or experts who do not engage in politics. To discuss political implications of policy or have politicians involved in the discussion is an infringement on a central banker's cherished independence. Only through independence and limited oversight can central banks do their sacred technical work. 

More overt discussion of politics will impact central bank behavior. There will be a biases when pandering to voters. This may be a bias toward inflation for the debtor class, or dovish policies that favor full employment. 

A central bank may have inflation and employment mandates, but central bankers, as a tribe, do not want outsiders overseeing or critically evaluating this process. Nevertheless, central banks are inherently political given their policies have strong distributional effects on the economy and citizens. There are choices to be made that will affect all citizens. There are trade-offs that move beyond the simple idea that a technocrat is trying to fine-tune policy instruments to hit some economic target.

Annelise Riles, an anthropologist and legal scholar who has focused on ethnographic research, has written a provocative book by taking a different perspective on central bank behavior. She explains the central bankers through an anthropological lens. These central bank experts form a community with social relationships which are outside the norms of the rest of society.



Central bankers have more in common with other central bankers and not the average citizens in the country where they work. Their success is gauged by their peers around the world and not by the average citizens they serve. Everyone leading player from the central bank tribe is likely to be a PhD economist and is steeped in the macroeconomic speak. They like their autonomy so they can focus on their community with little oversight by those outside their social network.

As we end the year with one more Fed meeting and growing focus on the number of rate changes in 2019, we should at least be aware of the disconnect between the tribe of central bankers and the rest of the economy and financial community. The focus of central bankers on quantitative tightening, normalization, forward guidance, rate mechanics, and bank regulation can be far afield from many who are interested in real wages and wealth accumulation for retirement. Monetary technocrats may be insensitive to the distributional effects of policy not only in their countries but around the globe. This is not a call for any specific policy but a greater awareness by central bankers of the indented and unintended impact of their actions. 

Monday, December 10, 2018

French political uncertainty not priced effectively

The cost of being wrong with political uncertainty is significant and the impact will be felt across many markets. The yellow jacket "uprising" has already shifted French economic policy and will also affect the direction of government. We may not be extremists but the fundamental pact between the governed and government is broken which is not good for any investments. 

The five-year CDS spreads are not reflecting the upheaval in France. Bond spreads have widened but don't seem to reflect the seriousness of the politics. Stock indices do not show any abnormal returns. The economic policy uncertainty index does not reflect these risks although there needs to be a new update.



There can be overreaction to rioting news, but the seriousness of these risks do not seem to be reflected in prices. Given close bond and stock substitutes in Europe, a conservative approach of avoiding France seems warranted.

Tuesday, December 4, 2018

Mixed trend signals between equity indices and bonds



The trend environment has changed over the last month. Bonds continue a strong up trend around the globe although equity indices have moved off lows and have started to trip buy trend signals. This pattern of buy signals for both stocks and bonds is not what is usually expected. 

Rates markets are now suggesting that central banks may not be as tight with funds. Eurodollar futures are starting to move higher based on greater disagreement on Fed action. Currencies are still showing weakness although the global macro story of strong US growth, Fed tightening, and flight to quality seems to have weakened. Gold is moving higher although the precious complex is not moving in tandem. The weakness in base metals has also fallen and now shows more mixed signals. Energy prices are still trending lower although there is greater uncertainty on further trend continuation. Natural gas prices have moved higher. Grain markets are moving higher albeit these commodity market prices are generally still flat. Broader commodities show more mixed signals.

Liquidity starts to decline quickly as we move closer to the holiday season and after the Fed meeting. The general pattern is that markets become more range-bound for the last two weeks of the year. 

Managed futures funds not able to find trends


This was a negative month for managed futures funds as measured by peer indices for a simple reason, range bound behavior in equities and a reversal in bonds. Equity indices have started to trend higher, but longer-term trend followers were not able to effectively exploit these moves in the second half of the month. Global bonds have trended higher for most of the month but smaller position sizes based on higher volatility limited gains. Oil prices offered strong gains, but the size of positions may not have large enough to make an overall impact on fund returns. Commodity trades are generally a small portion of total risk exposure for large funds.

Managed futures funds are unlikely to see a significant change in performance for the year in the next month albeit there are some stronger potential trends.

Saturday, December 1, 2018

November performance - Bonds say environment is negative, equities don't agree



Last month nothing worked with all asset classes generating negative returns. October saw a shift in market sentiment toward risk-off behavior. Investors started to take loses and adjust to more defensive portfolios. Momentum was clearly negative early in November, but monthly returns are sending different signals with both US and global equities higher. Nevertheless, it is too early to make any statement that risk-taking is back on. Equity markets have come off lows but are not showing any trends. Credit ETFs declined sharply relative to Treasuries and long duration bonds gained on new fears of economic slowdown. Commodities declined on a sharp fall in energy prices.

Our measures of risk appetite show we are in a period of transition and not a true risk-off environment. Economic fundamental data show some growth weakness after three strong quarters, but there is limited evidence for a bear market. Recession probabilities are still low. Risk-taking in EM has shown to be profitable. The market correction may have been overdone, but a more defensive focus is still warranted given the mixed environment.

Friday, November 30, 2018

Illiquidity premium and asset allocation - Mistakes in management even when paid a premium


If you have an asset that has an illiquidity premium, an optimizer will love it as a choice. An illiquidity premium is a dangerous area for investing. First, are you getting paid enough for illiquid? Second, is there a good way to measure illiquidity? Third, do you really know your liquidity needs?

There are two assets, one liquid and the other illiquid, for consideration. The illiquid asset has a slightly higher yield, a premium for less liquidity. An optimizer will choose the illiquid investment, all else being equal. The illiquid asset will have a smoother volatility. The optimizer will again prefer it versus a liquid alternative. An illiquid investment will not react as quickly to new information and will be less correlated to other assets. The optimizer will again prefer it. An optimizer will love an illiquid asset, and that is a problem.

Now, we have been extreme with our view of a two assets, but the point should be clear. There will be allocation distortions if you do not properly account for illiquidity.  Liquidity will never be available when you want it. Illiquidity will never improve from what was sold to you.

So how do you address the illiquidity problem? There are two simple solutions. First, rough-up the data by using a volatility that may be closer to the volatility of the asset class associated with the illiquid asset. This will downgrade the smoothness of the illiquid asset and will also increase the correlation with other assets in the asset class. Second, cut the returns that will represent the risk premia associated with liquidity. An optimizer does not think about liquidity. An investor should account for these factors.

What is PMI telling us about the stock/bond mix?


A big problem with macro fundamental investing is getting timely data on the economy and then translating that information to effective investment signals. Government issued data generally are out of date and old information for forward looking forecasts. Hence, there is greater value on macro data that is current and prospective. 

The PMI forecasts, which are announced monthly, are a good macro candidate given they are measured across a broad number of countries, have significant history, and are forward-looking expectations of economic activity. 

A graphically analysis of PMI explains the major sell-off in European equities relative to the US. It can also explain the decline in EM equity valuation. Similarly the PMI forecasts can tell us something about the broad trends in bonds. If the PMI is declining (increasing), there should be a bond rally (decline). Rates fall during declines economic activity. Investors just have to get an early signal. The current reading suggest that any switch away form equities should focus on bonds not cash. 

Friday, November 23, 2018

Categorization and classification - Fundamental to finance and investing


"Categorization is not a matter to be taken lightly. There is nothing more basic than categorization to our thought, perception, action, and speech. Every time we see something as a kind of thing... we are categorizing."   
- linguist George Lakoff
from The Geometry of Wealth by Brian Portnoy

Most investment work is about forming categories. We divide securities into asset classes. We make subcategories within an asset classes. We make industry classifications. We divide risks into different types of premia. There are value classifications. There are categories and classifications based on macro factors like inflation. Investors like to group. All scientists like to make groups and form clusters of similar things to find commonality.

The basics of science have always been about categorization. Whether animals, plants, or rocks, the basic work of observation and classification has been a core principle of observational science. Before there is theory, there is observation and the observation lends itself to systems of classification. Before we can offer explanation, there is a need for categorization and search for sameness and differences. Providing taxonomies helps us understand the world around us. 

Categorization is part of the narrative of science and a normal part of the storytelling of finance. The categorization is a heuristic for finding or describing correlation and similarity. The theory of finance attempts to look beyond classifications or categorization and in order to find first principles of what is an asset separate from any naming convention.

There can be a distinction between categorization and classification because most things do not fit into simple boxes. Classification is more formal and systematic based on rules. Categorization uses boundaries for similarities. See Elin K Jacob "Classification and Categorization: A Difference That Makes A Difference". The structure of categories and classification are not often discussed and just assumed, yet the choices are important.



By grouping stuff, we can find commonality and outliers that may suggest opportunity. The convention of what is a stock or bond or the distinction of what is an industry matters. The classification of an asset, which at times is seemingly arbitrary, has structural implications. Whether rated investment grade or high yield or whether included in an index or excluded, the category placement will have real return impact. How a manager is classified by the Morningstar service, or even how a hedge fund identifies itself matters for relative performance. 

So when building a portfolio and discussing allocation decisions across asset class, managers or risk premia styles, think about the implication of your categorization. The breakdown of asset classes or subclasses will impact investment decisions and return.

Thursday, November 22, 2018

Equity risk allocation - No change in exposure reduction view

It not a matter of like or dislike the fundamentals of equities in the current environment. When sentiment changes and volatility increases, reassessment of current exposures is warranted. However, concern about the macro environment should be increasing. Maintaining lower market risk exposure by more than half of core allocation from 60% to 30% or half equity beta exposure is appropriate. (The darker red signifies a stronger trend.)

Growth - While recession risks are still limited by any probability-based model, economic growth will be tempered in 2019 both in the US and rest of world. Earnings have not yet been significantly affected by growth, but forward expectations are now slightly biased downward.

Liquidity - Continued Fed tightening and expectations of tightening around the rest of the world serve as a negative for fixed income. High rates are starting to impact higher levered firms and lending. Make no mistake this is what central banks want. 

Risk Appetite - Higher volatility with changes in sentiment suggest market is moving to risk-off environment. Financial condition trends are pointed lower. With risk-off, harder to buy on dips so more downside follow-through.

Structural - Gridlock in government will negatively affect further tax reform and regulatory changes. Fiscal deficit is now pro-cyclical which will further affect rates.

Technical - There have been some key periods of divergence between equity style sectors. International and EM have actually been a place to hide in the near-term 




Looking over year-to-date, six-month, and three-month returns shows three distinct differences: The divergence between US and rest of world, the dislocation between large-cap and value, growth, and small cap equities, and the reversal of the earlier international underperformance. 

Wednesday, November 21, 2018

Can you improve on the 60/40 stock/bond allocation without changing the 60/40 allocation?


The classic 60/40 stock bond mix has proven to be a good core asset allocation. When in doubt, employing the simple 60/40 (SPY/AGG) asset mix as a base case has been an allocation that has performed well versus other diversification strategies. This allocation bias may be coming to an end. 

The gains from holding a US focused large cap equity and diversified bond allocation and not being further diversified across investment risk premia styles and international equity and bonds is a function of the recent performance and not special characteristics. Performance for both stocks and bonds is now off from the norms of the last decade. The correlation between stocks and bonds is moving higher. Volatility across equities and bonds is also trending higher. Something more defensive may be helpful.

Nevertheless, many investors are looking for a way to get defensive without a significant change to the asset allocation. There are simple defensive changes that can stick to a 60 percent domestic equity allocation and receive significant diversification benefit. Using the advantages of alternative index construction or smart beta can be a helpful simple strategy. (See Defense Beyond Bonds: Defensive Strategy Indices from SPGlobal.)





Smart beta strategies have performed well over a long period, but a better testimony of their current value will be with their ability to provide defensive benefit in a downturn. For those that want to maintain asset allocation and are not believers of active discretionary manager in any regime, the smart beta choices can offer some equity risk protection. First, the smart beta choices will change the mix of equity exposure, generally broadening the exposure away from large firms with momentum. Second, smart beta can focus on preferred characteristics like quality or low volatility that should provide defensive benefits.  

A tilt to long-only risk premia and away from market cap indices can preserve risk allocation while providing defensive characteristics. The same can be done with fixed income through reducing duration while maintaining credit exposure. A traditional 60/40 asset mix can be converted into a defensive 60/40 allocation. 

Monday, November 19, 2018

Fixed income choices - Move to further underweight


Current views on asset allocation in fixed income and credit are generally negative. The focus should be on holding shorter duration and cash investments. 

Credits spreads are widening because of both increased economic and financial risks. International bonds both DM and EM are facing dollar funding risks and slower growth. Long duration Treasury bonds show high risk even with recent rally. Underweight market allocation and risk weighing in fixed income and credit.

Friday, November 16, 2018

Spread widening can be costly - All is not well in credit land


It does not take much for an investor to have a losing credit trade on long duration bonds. The average duration on a long-term 10-year corporate is around 8 and current OAS spreads for triple-B corporates are 160 over Treasuries up from 120 earlier in the year. Half this move will take investors  back to levels seen in 2016 and wipeout all of the spread compensation for a year. This is not an extreme bet if we have any further erosion of equity prices or change in credit risk expectations, (See Corporate debt growth has exploded - The added macro shock sensitivity creates real risks.Shorter duration corporates will be at less risk given their lower duration but the stocking up of credit for yield reaching can be painful if credit risks increase.  

Even if investors hold the bonds for the longer-run, the marking to market will impact portfolio values. Holding less risk and moving to cash is a valid alternative, but this will place any investor at a severe disadvantage of reaching return targets. 

Portfolio protection is critical, so holding alternative defensive strategies need to be replenished. Any futures or derivative swap product may still allow investors to receive the risk free rate with excess returns associated with other risk premia beyond credit. The amount of excess returns from alternative risk premia can be dialed to a level of volatility that can match bond risk. 

Credit investing was an effective investment choice when rates were headed lower, spreads were higher, and the economy was improving. A new environment of late business cycle risks, falling equity values, Fed tightening, and spread widening requires different thinking.


Thursday, November 15, 2018

No diversification in Mudville - Time to try different risk premia styles


Diversification is usually thought of as a longer-term concept. Don’t worry if it seems like you are not receiving diversification in a given month or quarter. Think about diversification across a longer horizon.  Diversification also does not guarantee better returns for a portfolio. Negative diversification does mean that your losers will be offset with winners.

Yet, investors often look for diversification protection over short periods. If stocks are going down this month, they are looking for an offset this month. If stocks have had a bad quarter, investors are looking for something good this quarter. That is wishful thinking. Correlations change and the measure is about co-movement relative to mean values.

This year has not been good for diversifying assets like fixed income. Our simple chart shows returns for equities and some of the leading fixed income alternatives: the Barclay Aggregate, mortgages, long duration Treasuries, investment grade credit, and high yield. None have worked well at portfolio protection even though fixed income volatility with the exception of long duration Treasuries is less than half of equities. Investors are taking on a high degree of credit and rate risk during Fed tightening late in the business cycle. 

An alternative form of diversification is to breakout of asset class risk and switch to style risk that is focused on alternative risk premia. The concept of alternative risk premia is to isolate the risk within an asset class to some constituent components like value, carry, or momentum. This diversifies risk on another level beyond asset class or beta exposure. When blended across a number of premia, this diversification can be done with or without making a focused class decision.

Monday, November 12, 2018

Evolution and adaption: Trend-followers are constantly changing


Hedge funds styles, strategies, and firms evolve over time. The behavior of a hedge fund today is not the same as yesterday. These behavior changes are not because a manager has changed his style but because the environment, the tools, the regulations, and the ideas surrounding finance are different. 

Of course, many of the guiding principles for a hedge fund are the same. Value managers attempt to find cheap assets. Trend-followers attempt to find trends. The evolution is generated through changes in technology, the structure of markets, and the implementation of strategy ideas.  Technology implementation allows for cutting costs, enhancing skill, and gaining scale. The structure of markets requires managers to evolve. New ideas and knowledge help generate or improve skills.  

Managers who are not thinking how to adapt will see their returns deteriorate and ultimately fail. Technology not used is a lost opportunity or places a manager at a competitive disadvantage. Ideas not employed hampers skills. Avoiding adaption reduces opportunities and increases costs. Adaption is core to good hedge fund management, yet being adaptive to changes may not lead to higher returns. Competitors are doing the same thing. Adaption may be required just to stay even with other managers in the sector. Some structural changes may lead to lower returns

We have discussed the evolution of trend-following in the past, (see The evolution of trend-following firms to alternative risk premiums and quant shops), but the current environment requires more thought about firm evolution. Limited crises over the last ten years and greater competition means trend-following has seen a more constrained opportunity set. Managers have to adapt to exploit or enhance these existing opportunities and prepare for changes as we move further away from the last crisis.

The evolution of trend-following has followed a set of three intersecting paths: technology, structure, and idea generation. These intersect because some ideas can only be implemented if the technology is available, and some technology can only be used if there is a structural environment that allowed implementation. Investors need to ask how firms are addressing these intersections.

Technological improvements from computing power have been especially relevant for quant strategies like trend-following. The computing power has been directed into four areas: 
  • The use of speed to test new strategies through back-testing - any idea is quickly testable.
  • The low price for storage - any amount of data is easily stored and available for review.
  • The ability to electronically trade and parse orders to reduce transaction costs.
  • The ability to process operations and manage risk - process and overhead can be reduced and position knowledge is readily available.
Idea evolution has allowed for better return opportunities and risk management; however, the broad use of new ideas diminishes the marginal edge given to any one manager. The major ideas that have affected trend-following include:
  • The risk management revolution including VaR modeling.
  • The improvement of portfolio management including volatility targeting and equal risk contribution.
  • The use of new statistical tools for teasing out time series behavior.
  • The ability to engage in complex non-linear thinking like machine learning.   
Structural changes have reshaped the set of opportunities for managers:
  • The introduction of new derivatives markets - Trend-followers have more markets to trade than before.
  • Changes regulation that allows new products  - Regulation has allowed for new fund structures that change the investor base.
  • Changes in policy affect price behavior - Changes in monetary policy has affected the behavior of rates which impacts trends. Changes in capital regulation opens new markets. 
  • Changes in industrial structure - The concentration and behavior within industries affect price opportunities.
An assessment of how firms are dealing with change may provide answers on which firms will be able to come out on top in a changing investment world. Unfortunately, firm adaptation is not a guarantee for higher returns when we are in a competitive environment.

Sunday, November 11, 2018

Blending risk premia and generating craftsman alpha


Alpha generation will fall when it is measured correctly through an appropriate benchmark. Alpha shrinkage over the last ten years is a measurement problem. Returns for hedge funds are a combination of the underlying risk premia styles employed and the skill of the manager. 

This shrinkage seems to suggest that managers generate little extra return through their skill, but there are other forms of alpha associated with forming a portfolio. This has been called "Craftsman Alpha" (See Craftsman Alpha: An Application to Style Investing). The crafting or forming of a hedge fund portfolio is a unique skill and can provide value no different than security selection.

The definition of craftsman alpha is still somewhat vague, but it will include all of the activities associated with portfolio management after a style choice is determined. Craftsman alpha will be the value-added from bundling and managing a portfolio of risk premia. 

We break craftsman alpha into four categories or parts:
  • Risk premia style choices -
    • Implementation of styles: Given any risk premia style, there are a number of implementation choices, asset restrictions, inclusions and exclusions, and definition differences, which determine how a style is generated. For example, a FX carry strategy has to determine the currencies to include, the rate to determine carry, weight constraints, and rebalancing to name a view. These choices, all under the name FX carry, can have appreciable return differs and can be classified as skill. 
  • Portfolio management choices -
    • Volatility targets; determining the overall risk of the portfolio 
    • Rebalancing timing; determining when to reset the weights of the portfolio. 
    • Sector and name constraints; determining maximum allowable exposures.
    • Weighting scheme; determining the weights of exposure such as equal volatility weights vs equal risk contributions. 
  • Execution choices -
    • Mechanisms for minimizing transaction and trading impact.
  • Dynamic Adjustment choices -
    • If there are multiple risk premia in the portfolio, the decision process or mechanism for adjusting the portfolio weights.
A craftsman alpha discussion changes the focus from picking securities or risk premia to the process of managing a portfolio of risks; the strategy and tactical decisions of running a portfolio. Given there are no well-defined rules on how to create craftsman alpha, there can be significant variation across managers. These construction choices are the decisions of a craftsman and not scientist. 



  

Friday, November 9, 2018

Alpha production - As we get better at beta measurement, alpha will decline


A growing investment management theme over the last few years has been the incredible shrinking alpha. As investors gain more information on risk premia, there seems to be less alpha produced by managers. In reality, alpha production has likely not changed, but our measure of alpha has gotten more sophisticated so the skill associated with any manager seems to have declined or at least changed over the last decade. We can now tie what was previously thought of as alpha to specific risk factors. If alpha is tied to systematic risk factors, then it really is not alpha.

The measurement of shrinking alpha can be described in an alpha pyramid. As investors better define portfolio risks, the skill of the manager will shrink. It is harder to prove skill when we account for risk premia correctly. (See our previous post, The incredible shrinking alpha - Falling skill or alternative definitions?) It is hard to get to the rarified place of skill after accounting for risk factor premia. 

It can be affective to think through the process of moving up the alpha/beta pyramid. A stronger beta filter will reduce the number of managers who are special alpha producers. As we enhance our skill at measurement, the manager alpha skill has been more difficult to find.

If the majority of returns are associated with risk factors, there will be less room for alpha. If this is true, then building risk premia portfolios may better serve the diversification and return needs of investors. Find the betas that will enhance the return to risk of the portfolio and don't worry about finding that special skill manager. Of course, if you can find the high level manager hold onto him; that manager can indeed be very special. However, the search should be on finding the best risk premia mix.