August market performance - All about breaking the 7 CNY price

After the Fed announcement in July, it looked like August had the potential to be a quiet summer month, then the RMB broke the 7 barrier and the trade war took on a new negative dimension. We have switched to currency wars after the US Treasury declared China a currency manipulator. Oddly, their actions before August have been to stabilize the currency and control volatility as opposed to letting it fall to offset tariffs. The currency moves seem consistent with the underlying China economics. 

With the currency breaking through the seven level, viewed as a key policy barrier, markets reacted violently. Investors who knew nothing about China's currency now watch every daily movement for signs of trade war escalation. A lower currency can offset some of the cost of the tariff for importers, but it has further ramification with capital flows and dollar liabilities for Chinese companies. The uncertainty of what may happen next to currency markets certainly impacted all risky assets. The flight to safety in long bonds was spectacular with TLT jumping higher by more than 10 percent. This bond move reinforced the global push to lower rates. 

The Jackson Hole monetary conference only reinforced the unsettling verbal war between central bankers and politicians. This is not a US problem but a global issue. Politicians want central banks to further manipulate rates to jump start growth without the pain of adverse fiscal choices. 

With continued dynamic trade war rhetoric, it is hard to make any judgments on the direction of risky assets. A September Fed meeting only makes for a more chaotic monetary environment of either action or no action based on politics and not data. With long bonds now generating over 20 percent year to date returns, the safe asset does not look so safe going forward. Perhaps US T-bill rates look like the best alternative.

Negative Interest rates as "Financial Vandalism"

Bond vigilantes, who have caused prices to slap-down bad policy proposals, have disciplined politicians. Dollar bond votes sent a message to policy makers and cut-off bad economics. Now we have financial vandals who manipulate prices to destroy market structures. These vandals don't actually eliminate financial institutions and structures, but generate price distortions to subvert markets through bending financial rates and upending normal behavior. In this case, the policy vandals, through central bank power, force rates into negative territory.  

These financial vandals are not hoards of Wall Street traders, bankers, or pitchforked carrying savers. No, these vandals carry PhDs and talk in hushed tones in central bank corridors and legislative bodies. You won't see them doing any financial dirty work out in the streets. Instead, they will tell you that their policy vandalism is necessary to help people and the economy.  

The policy of negative rates has an adverse impact on savers and retirees. Retirees who expected cash flow from higher yields have to rethink their portfolio structure as well as time to retirement. The expectation that savers will gain from a wealth effect and increase their demand to consume today versus tomorrow is offset with the view that more savings is necessary because real rates generate no gains. Negative rates will not help pension funds as these institutions are crippled under their new greater actuarial responsibilities. 

Changes in payment terms and free money will not discipline debtors to behave more responsibly. This approach to finance is especially odd since the problem during the Financial Crisis was too much leverage and debt and not too little. Unfunded liabilities that cannot be met in the future because of low rates will not build financial confidence today. Policies can be used to nudge behavior to get the right solution, but global rates in negative territory have not moved growth higher. We are only left with the counterfactual argument that the global economy would be worse if rates were positive. The glut of global savings has yet to be solved through financial pain inflicted on savers. 

The key investment problem of the decade; take on more risk or suffer from lower yields. The only way to break this problem is to think outside traditional asset management and focus on core factor risks. Reweighing factor exposures outside fixed income may offer some solutions to the current yield vandalism 

Emerging markets and US rate shocks - Easy dollar credit makes for better EM bond returns

Whether we like it or not US monetary policy impacts the rest of the world. A dollar-dominated world means that tight or loose monetary policy in the US will affect the rest of the world, especially emerging markets. There are benefits with a dollar world but also responsibilities. Investor have to track US rate shocks and right now a lower of rates will spill-over to EM rates and equity returns. This is especially the case when the rest of the world is slowing and there is a monetary policy disconnect.  

The US and EM link is documented in one of the key papers at the Federal Reserve Bank of Kansas City's Jackson Hole Economic Policy Symposium, "US Monetary Policy and International Risk Spillovers" by Sebnem Kalemli-Ozcan.  We have posted a blog that global r-star impacts US rates (see Low r-star as a global issue - Implications for global asset management), but US policy shocks impact other countries especially emerging markets.

While there are limited rate differentials in developed countries, there is more dispersion in rates between the US and EM countries. There are greater risk differentials and these rate spreads will increase with global risks as proxied by the VIX. The VIX serves as a global risk sentiment. A shock to US rates will impact sentiment across EM rates. Tighter (looser) monetary policy in the US will increase (decrease) spreads in EM rates. More US credit will affects risks and global funding. 

Declines in US rates will carry-over to EM risk premia through declining rate differentials. In a weak EM environment, a Fed policy of cutting rates will tighten premia and offer better global bond opportunities. For 2019, we have seen emerging market bonds outperform US and DM bond portfolios and the international AGG has outperformed the US AGG index even with a slight dollar increase. EM bonds will be attractive in a looser Fed monetary policy environment.

Low r-star as a global issue - Implications for global asset management

The natural rate of interest has been moving lower not just in the US, but around the world. This should be no surprise; however, the reasons for the decline should concern asset managers. The falling r-star has been measured in the new paper "Riders on the Storm" by Taylor and Jorda as prepared for the recent Federal Reserve Bank of Kansas City Economic Policy Symposium “Challenges for Monetary Policy,” Jackson Hole, Wyoming, 2019. More importantly, r-stars around the world is more correlated. No economy has escaped the decline in the natural rate. This correlated decline affect how central bankers should think about monetary policy as well as how global investor should make allocation decisions. 

Measuring the natural rate of interest (r-star) is important because it can serve as a guide for where interest rates should be and whether monetary policy is tight or loose. The current natural rate global average is negative and has been since the Great Recession. This negative average exists even with current positive global growth. Non-growth factors such as demographics have driven the natural rate to such low levels. Not only are the factors that drive r-star falling but they have become more synchronous. 

Output gaps, monetary stances, inflation, growth, and other factors are all more synchronous and with lower dispersion. The great trade growth since the introduction of the WTO has integrated world economies. The factors that drive interest rates in any country are all similar, so any decomposition of rates shows that the world natural rate has an increasing impact on local rates. The US cannot escape from the global r-star connection. Regardless of political talk, US rates are pulled lower based on world dynamics.

The synchronicity of global economies and natural rates has spillover to all global macro investors. US rates will not move out of tandem with global rates. Investors cannot fight world trends. The bond rally, regardless how much rhetoric of a bubble, is not over until we see signs of global r-star moving higher. Given the tight global relationships in growth and other factors, there is less opportunity for global diversification in either stocks or bonds. There is no escaping systemic global risk. Flight to safety will only further correlate rate links so there will be few places to hide during the next downturn. 

Jackson Hole Meme - We cannot solve all growth problems with monetary policy

Aside from the papers presented, a major theme of the Jackson Hole Kansas City Fed central banker conference was that monetary policy cannot solve all economic problems.

Monetary policy can create and solve issues with inflation. Monetary policy can create and solve problems of credit. It can do its job by providing the liquidity needed for sustained growth. When working monetary policy is a lubricant to the growth engine not the engine itself. Forward guidance by definition has limits. It is supposed to reduce uncertainty and ambiguity but central banks cannot create growth through words. Monetary policy can be effective but less so as we rates reach the zero bound.

Monetary policy cannot solve trade wars. It cannot solve productivity issues. It cannot solve demographics or issues of regulation. It cannot close disparities disparity in wealth although it can increase the value of financial assets. In fact, taking monetary policy to extremes with negative interest rates will only lead to economic distortions that will have to be solved later. Without coordination, monetary policy in one country cannot solve global growth problems.

Monetary policy is political but the politics are different from fiscal policy where the legislative process creates distortions through power dynamics and is often slow moving. Monetary policy is a tool but the only tool. Central bankers have to tell all that they have limits. Politicians have to accept those limits and take on more policy responsibility. 

This does not mean investors should forsake focusing on monetary policy, but there should be a greater awareness that the Fed is not a solution to a problem but a contributor to the problem. Further cuts may occur, but what ails growth is not high interest rates but more systemic problems. Be prepared for selling pressure on monetary easing as the meme of money impotence grows.

The upside down, inside out negative yield financial world

As Keynes has said “The market can stay irrational longer than you can stay solvent.”

Fixed income investors are having a great laugh with strong bond performance this year as yields move further into negative territory in many countries and close to all time lows in the US. The individual facts are astounding. The German government issued 30-year bonds with negative rates. The Austrian 100 year bond is at a zero rate. 44% of the Barclays/Bloomberg Aggregate index outside the US is negative. The dollar amount of negative yielding bonds is now $15 trillion. The Eurozone investment grade bond index has a yield to maturity of .24 bps. Every basis point decline in yield places more debt into negative rate territory. You can now borrow for a negative rate mortgage in Denmark.

Try explaining negative rates to anyone and you are immediately placed in an odd world. There is no normal time value of money. Yes, there is time value except a lender will give you the use of their money today in exchange for less money tomorrow. A borrower can obtain money today with the promise to give the lender less money tomorrow. The lender says that he has no known use for his money and would rather give it to someone else in exchange for less money in the future. 

The credit is willing to take a penalty for giving up the use of their capital as debt. They must be very afraid of future returns for equity. While there are other alternatives, creditors are willing to lock-in a sure loss over the uncertainty of something else. Note that holding paper money will lock-in a loss of zero. The risk of inflation applies to bonds and cash. Insurance companies with long liabilities are saying that they will take a penalty to closely match their long-term obligations and there is little fear of any future inflation. Creditors are driving up bond prices to create negative yields, a form of scarcity. 

What is as surprising as creditors accepting these negative rates is the lack of new government bond issuance at these rates. For all the countries that have negative rates, it seems that they should be exploding their balance sheets for any capital improvement project that has a positive net present value. This should continue until rates are driven higher. 

You can spin this story a number of ways and still generate an absurdity. If normal creditors and lenders cannot provide a reasonable story for their negative time value of money, we are left with an explanation that these negative rates are imposed on the markets as a form of financial repression by central banks. 

This cannot continue. This is an easy comment to make, but one that does not help the investor who has to take action today. "The markets can stay irrational..." Still, investors should be looking for any uncorrelated alternative to this bond bubble.

Looking inside the BAIT box - A Checklist for thinking about who is on the other side of a trade

When thinking about any investment, use BAIT to ask questions. BAIT is the acronym developed by Michael Mauboussin in "Who is on the other side?", and is a great way to describe this important issue. For every buyer there is a seller so any investor should ask why anyone should be on the other side of a trade. The acronym stands for the possible advantages of a manager: Behavioral, Analytical, Informational, and Technical. 

Behavioral - What is the market telling us through investor behavior?
Market price action is driven by the behavior of market participants. They are subject to a host of biases, so an investment has to understood relative to the biases that may currently be driving price action. Are forecast being extrapolated? Is the market focusing on just recent information? Is sentiment far from normal? This behavioral information may help with mean-reverting trades and where there are large risks of being wrong for a rational contrarian view. 

• Are investors just extrapolating their perceived forecast skill? Are their forecast based on general knowledge, "news"; special information like brokerage analysts, or private forecasts?
• Is there performance chasing of asset returns? Is selling or buying based on trend or momentum?
• Is there too much consensus among analysts? Is everyone thinking the same?
• Is current sentiment at extremes?
• Is there a correlation of expectations? Is a sell-off based on a general market perception?
• Are there deviations from well-defined value models? Are these deviations going to reverse?

Analytical - What is the level of complexity for the investment? 
More complex investments have fewer potential buyers and sellers. There is value with understanding investment complexity, but this also means that you will eventually have to find someone to buy this complexity from you at a favorable price. Perhaps it is better to invest in complex markets that are not perceived to be complex. More complex investments are less liquidity because there are fewer knowledgeable investors.

• How complex is the investment?
• If you have to sell, who will be the potential buyer and how smart does he have to be to make the purchase?

Informational - What is the information missing from the market?

Information is a commodity whose value is variable. Public information released by the government by definition may have less value than information that in manipulated or constructed by a manager. For public information, the value is in the surprise. Public information value is dispersed quickly while private information may take longer to infect a market. As an investor, are you using all of the information that is available and do you have access or employ information that is not embedded in prices or used by others? There is value with manipulating information in a novel manner. 

Markets may weigh information differently than you, so a real question is whether the market will come to agree with your weighing assessment. Understanding how information is weighed may be critical to investor success.

• Is the market missing information or not reacting to data as expected?
• Are you paying attention to all information?
• How do you weight information relative to the market?
• Have you noticed changes in the market's weighting scheme?

Technical - Are there technical drivers for market behavior?
Technical factors are associated with endogenous risks, or risks that are associated with market behavior. Fundamental information is exogenous or created outside the market. Investors need to be aware and use both to make successful investment. For example, capital flows provide headwinds and tailwinds for investors. Prices react to stop levels, moving averages, and new highs to name just a few. Technical awareness can make a difference on entry and exit levels. 

• Are funds flows correlated with performance?
• Is there non-information technical flows pushing markets?
• Are there forced buyers or sellers?
• Are arbitrageurs maxed out allowing markets to react beyond normal?

Once you think of investing as a multi-player game, it will be easier to formulate reactions to your behavior and news. Without a framework it is easy to overthink what markets may do in many situations.  Checklists for markets reactions make decisions easier.  

Inverted yield curves - Is this time different? Perhaps not but look at the financial cycle for help

Market volatility has increased on the news that the Treasury yield curve inverted for 10/2-year yield spreads, albeit temporarily. We already have an inverted curve from the front-end so this further inversion was not really new news. It caused the inversion story to reach the headlines but has not changed the overall recession story, yet there have been some analysts that have argued that this time is different. There will always be contrarians, so it is important to look at other information that may support or reject a recession story.

The Bank of International Settlements (BIS) has published some interesting work on other financial factors that may have strong predictive power for a recession. Their research provides a direct comparison with the inversion story and suggests that the likelihood of any recession will be related to the financial cycle. 

The financial cycle according to the BIS "refers to the self-reinforcing interactions between perceptions of value and risk, risk-taking and financing constraints." The financial cycle does not match the business cycle and can last at least 15-20 years. The BIS researchers conclude that a financial cycle downturn is a better signal than an inverted yield curve and a combination may provide superior information. Inversion with a financial cycle turn is a strong recession signal combination.

The financial cycle story is one of credit excess. An increase in credit will inflate collateral prices which in turn leads to further increases the amount of credit that financial institutions will lend and borrowers will take-on. At some point the there will be an adjustment in collateral prices which will lead to a feedback loop of collapsing credit and further declines in collateral prices. The peak in the financial cycle will occur when there is a banking crisis or an increase in financial stress.  There may be a slowdown or recession with a yield curve inversion but the bigger and more meaningful signal is stress from extremes in the financial cycle. 

In the BIS Quarterly Review December 2018, the presentation "The Financial Cycle and Recession Risk" shows that a probability measure using a proxy for the financial cycle from BIS available data is a better recession indicator over both short and longer-term horizons. They find that a simple variable to use for financial cycle stress is the debt service ratio; see the BIS website for easy to read tables. Extremes in debt service provide the environment for a decline in the financial cycle which can predict a recession.

  
Debt service ratios for the private non-financial, household, and non-financial corporate sectors suggest that we may not be at an extreme. Some countries have reached highs but the US, while elevated are not at excessive levels. The power of lower interest rates has allowed creditors to handle higher debt levels. A similar story can be gleaned from the credit to GDP numbers. Trends suggest that credit levels are high, but not at extremes that place the financial cycle under stress. Now this can change if there is a shock to collateral, but yield curve inversions are noisy forecasts. Near-term concerns of recessions can be tempered; however, the feedback from costly high short-term rates on long bond investing and risky investing in general is real.  

Bonds are expensive - Yet fighting irrationality is not easy

Cliff Asness  -  "Bonds are Frickin' Expensive"

As a boring economist, I will not use his colorful language, but the current fixed income world is not normal and bonds have gotten all the more abnormal over the last three months. Treasury 10-year bonds have seen their yields cut in half in a little over 6 months. Long bond rates are touching all time lows since the Financial Crisis even though we are not in a recession. Bond futures prices have skyrocketed with an increase of 20 points since March. The rally has been driven by outside capital buying higher US yields, a flight to safety for some investors, and speculative expectations of further Fed cuts. It does not matter who is driving the buying. Bonds are reflecting extreme expectations.

These extreme expectations are not just from strong short-term buying. Beyond price technicals, there are a number of fundamentals that point to expensive bonds. The term premium or excess yield necessary to hold longer-term debt has turned negative as measured by the NY Fed. These negative premia have been negative for over a year, and continue to trend lower. The yield curve has inverted based not just Fed tightness but on strong buying pressure at long durations that have pushed yields lower faster than the front-end of the curve. The yield on bonds are less than the cost of financing in the repo market, so the only reason to hold is based on expectations of further yield declines.

Inflation, albeit low, when subtracted from nominal rates suggests negative real returns. Real rates may go negative when there is a surprise shock to inflation or a central bank pushed rates lower, but these negative real rates is based on strong bond buying not inflation surprises. Looking at the relationship between the yield slope, real yields and industrial production, Cliff Asness argues for bonds being expensive. Industrial production does not justify the bond rally. 

Unfortunately, we are not in a normal world nor is it likely to become normal in the near future. Investors have to accept continued irrationality and be bond buyers or assume the world will move to rationality, avoid bonds, and potentially miss what could be a great fixed income opportunity. We have seen this story before in Japan and Europe. Investors do not believe a bond rally can continue and only further rate declines. Investors are forced to make choices that would have thought unacceptable in earlier times.

I like this "Keynes quote" even if he never said it

If you are in money management, you make predictions. This is the life we lead. We get new facts and have to change views. Admitting that new facts should change opinions is core to learning. 

The Keynes quote should always be in the back of your mind when making investment decisions even if Keynes never said it. There are many great Keynes quotes but this is not one of them. Reading about how often this quote has been wrongly attributed to Keynes is a great story. There is no reference to it, nor can any of his great biographers recall him saying it. See Quote Investigator, a useful source of information that supports this story. 

Some attribute the quote to Winston Churchill. The closest quote to possible fact was a comment by Joan Robinson who knew Keynes well and attributes the following to him, "When someone persuades me that I am wrong, I change my mind. What do you do?"

Keynes was a excellent debater and was known to adjust his opinions to win the argument. He also was a fluid thinker who changed views as information changed. One notorious story says that Churchill sent Keynes a cable reading, “Am coming around to your point of view.” Keynes is said to have responded, “Sorry to hear it. Have started to change my mind.”

Paul Samuelson actively used the Keynes quote. He also commented on the changing opinions of Keynes. "One of the jokes is that if Parliament asked six economists for an opinion on any subject they always got seven answers. Two from John Maynard Keynes. I think when we economists examine the seven answers we find that the discrepancies among them are not as great as the layman thinks."

Regardless of history, it is a good quote to follow. We will just have to stick with the line from John Ford's The Man Who Shot Liberty Valance, "This is the West, sir. When the legend becomes fact, print the legend." 

"In God we trust, all others bring data" - W. Edwards Deming as a data systems guy

"In God we trust, all others bring data."

"Without data you're just another person with an opinion."

"If you cannot describe what you are doing as a process, you don't know what you are doing."

Call him old school. Ed Deming was one of the originators of total quality control and revered for his management principles and is revered as a management god in Japan. If you were thinking about a manufacturing system design, you likely followed the principles of Deming. His ground breaking work is somewhat forgotten, although concepts of quality control are focused on the minds of most manufacturers. 

His thinking should resonant with those who are at the forefront of system design and data analysis for quantitative analysts. As more complex quant systems are built, issues concerning quality control should be always be on the minds of designers.

Take some time to think about the Deming quotes, they are worth internalizing. Deming's views should be front and center for any investment committee where managers bring their feelings about the markets. Experiences and hunches are fine, just bring your data. 

Who is really being held hostage or being a kidnapper - Markets or central banks?

“Even though further cuts are not justified by traditional economic metrics, the Fed will have no choice but to reduce rates. The markets are holding them hostage right now,” said El-Erian, the former co-chief investment officer at Pimco, the bond house. - from fnlondon.com

This is a poor choice for an analogy, but perhaps the logic for central banks should be reversed. The decade of QE was a market kidnap by the Fed to manipulate growth. The engineering of negative rates by the ECB was another financial market kidnapping. The huge balance sheet expansion by the BOJ was still anther kidnapping. Large foreign currency reserves held by other central banks are resources to help with market kidnapping. Forward guidance is just the threat of market kidnapping by central bankers. 

I am always moved by Hayek's comments on the wisdom of prices for communicating knowledge as a first principle of economics. This knowledge and wisdom cannot be imparted when prices are manipulated in order to engineer an economy. Manipulation may result in unintended consequences as investors respond to these non-market prices. A market is held hostage when prices move against the will of those making economic decisions for investment and consumption. When economic agents driven by their interests move prices, it is not manipulation. 

We are not arguing that Fed should be passive. Rates changes are a tool to support the Fed's dual objectives of stable prices and growth. However, rates cannot be used to subvert the natural behavior of business and credit cycles. Rate manipulation distorts price discovery and the behavior of market participants. 

Rational expectations tell us that market participants will anticipate central bank actions and adapt. When investors are anticipating further central bank market manipulation, there are not holding the Fed hostage but acting on past Fed signals. This is an ironic role reversal. 

How much is too much rate manipulation? Hard to say since the Fed kidnapper will argue that it was done for the good of the hostage. The Fed will argue the counterfactual that economic life would have been worse if its policies were not implemented. We are close to hearing, "I am manipulating prices for your own good.", or "I don't want to lower rates but you are making me do it". 

There needs to be a middle ground for supporting growth but not distorting the allocation of resources in the real economy through suppressing yields to create unwarranted growth with excessive credit expansion. After months of forward guidance that rates should be lower and allowing markets to anticipate multiple rate declines, is it surprising that markets have gotten ahead of the Fed?

Stealth CTAs - Away from the negative hedge fund news, systematic and trend are doing well

Managed futures trend-following can be a stealth hedge fund style. Predicting hedge fund behavior by style is not easy. For example, the trend-following style is structured to be non-predictive. Trend-following models generally do not try to predict trends but just identify them and then invest. Any investor should find a trend-follower making predictions about the macro environment odd. At best, they should say that trends will continue. 

If there are trends, trend-following should make money, but it is a necessary not a sufficient condition for success. Nevertheless, there is a link between price trends and fundamentals. Divergences or dislocations in fundamentals will impact prices. Trends in fundamentals will create trends in price. Success with trend-following is more likely if there are market dislocations, but defining when there will be a crisis is fundamentally difficult. Crises are infrequent and are usually unanticipated. 

Investors should play the odds that show trend-following works over the long run and has been consistently positive across asset classes. However, that is not the same as arguing that a particular year should generate positive returns. Other then saying that the trend-following investment style is overdue for better performance, there was little in the tea leaves to predict success at the end of last year. Those who were expecting a recession argued that a long/short diversified trend strategy would do better than a long-only risky asset strategy but this was predicated on financial crisis scenarios. Yet, here we are in August with managed futures (generally trend-following) indices showing potential for one of the best years in the last decade. 

Reviewing markets over the last seven months suggests that trend-followers who focused on fixed income were able to take advantage of two fundamental trends that may not quickly disappear. First, there is a global central bank bias to create liquidity with forward guidance that rates should come down. The Fed has been proud of its jaw-boning to place downward pressure on rates. Second, there been a slow decline in global growth that has provided support for the downward yield movement. 

There has never been a bond rally that trend-followers have not liked and those who have had high bond exposure, either by model design or because of size, have been strongly rewarded. Funds with more diversified exposure have under-performed on a relative basis. Nevertheless, opportunistic trends in equities, currencies, and some commodities allowed for added gains for the nimble manager.

Further gains in trend-following are predicated on our two fundamental trends; one, a continued central bank bias to supply liquidity and two, a deceleration of global growth. Fundamental trends create price trend opportunities and strategies that are fully diversified and willing to take long and short positions will have an edge at generating returns versus a focused long-only investment.  Price trends last longer than expected because fundamental trends last longer than expected.

Hedge fund performance for global macro / CTA - Strong showing

There are surprising performance dynamics arising for hedge fund strategies in 2019. A positive expected return for equity focused hedge funds is expected when there is a high market return year. While the returns may not match market portfolio given the low beta for many hedge funds, the combination of alpha with some market exposure should generate good performance. We have seen these expected equity hedge gains with the HFR index fund averages. 

The strong showings for global macro and CTA managers this year have been surprising. Global macro and CTA managers have received a lot of bad press the last few years given their lackluster returns, yet 2019 index averages through July have shown good positive gains. However, the HFR indices do not do justice to the strong performance for some managers and strategies. While there has been significant dispersion in returns, some managers have shown their best returns in years. This recent performance has been independent of any “crisis alpha” story, albeit the threat of a global recession has risen significantly over the last year. With some extended trends especially in global fixed income, global macro has been able to provide gains through a different return stream. 

Diversified stock/bond portfolios have also done well during this period, so the true strategy test will come as we move into the last four months of year. If there is an equity decline that causes long market beta positions to flip negative, the dynamic global macro strategies will be all the more successful. If this market change is gradual, average systematic macro/CTA managers will close the year with of their best recent returns

Once again the volatility-selling evil investor is back

Volatility spiked last week and we again were reading stories about how this was intensified by systematic traders who were cutting positions as a knee-jerk response to the initial volatility shock. We don't dispute that expected returns respond to volatility or that risk management may lead to further market selling. It is the level of feedback that is unclear. Investors have to get used to the fact that this volatility feedback loop is here to stay.

Our simple diagram shows how a shock to markets will lead to a feedback loop and the potential for more selling and an increase in correlation for those markets within an asset class. We have not shown the impact of dealer adjustments from gamma trading which is another feedback path.

A volatility feedback loop exists for any investment manager that uses VaR as a means of measuring risk and for any asset manager that adjusts positions based on volatility or targets portfolio volatility. The exogenous volatility shock affects trading behavior which leads to endogenous risks that lead to further increases in volatility The only question is measuring the size of the impact between portfolio behavior and volatility and the speed of the response to an initial shock. Investors should not be complacent to the feedback from volatility shocks.

If you have not noticed, there is a lot of risky debt outstanding

Sometimes investors have to be hit over the head with a 2x4 to notice risks. This week saw one of those 2x4 moments. High yield spreads as measured by the BAML OAS spread index for both high yield and BBB-rated bonds exploded wider with increases of 50 bps and 15 bps respectively. This was a 10+ percent increase in spreads based on last week's spread levels in both markets. Investors talked about the difficulty of finding liquidity in these markets. While the market seemed to calm by the end of the week, there was only a limited reversal in spreads. 

The debt market structure suggests there is a lot of risk in credit investing. First, the amount of the lower-rated bonds on the cusp between investment grade and high yield has never been higher. Second, the ability to pay as measured by debt to EBITDA could not be worse.  

These conditions are unlikely to change even if there is further Fed rate cuts. Debt supply has not slowed even when rates were rising. Any decline in earnings will hurt the denominator in the debt/EBITDA ratio. There are buying opportunities and liquidity warnings. While the reach for yield may intensify if absolute rates decline, this week was a warning. Fundamentals are not good, so spreads have little reason to tighten. 

Everything you need to know about ETFs and volatility on a 3X5 card

While there are significant benefits and cost advantages from ETF, their growth has impacted the price process for assets. Research suggests that ETFs have an impact on the volatility of the underlying assets associated with the ETF through a short-term liquidity effect. This research is a few years old so the impact may only be greater today with the continued rise in ETF volume. (See for example "Do ETFs Increase Volatility" Journal of Finance December 2018.) 

This volatility discussion is more important because of the strong growth in ETFs with underlying assets that are less liquid. For example, the strong growth in fixed income ETFs, especially with high yield indices, creates an environment where the underlying bonds within the index will see higher volatility based on the flows associated with the ETF. 

ETFs have attracted shorter-term traders (higher turnover clientele) than the underlying assets, so their activity spills-over to the assets included in the ETF. Liquidity traders, not new price discovery, increase negative autocorrelation in the underlying assets. The increasing endogenous risk from changes in market structure from growing ETF usage may have gone unnoticed by many investors in the current relatively low volatility environment, but a change in the environment that may see more rebalancing and asset allocations will spill-over to volatility and co-movement of individual assets. 

The next financial crisis will be different from the last and the impact of ETF flows may be an important part of the future market dislocations. The new "bank runs" will be in financial assets and not just depository institutions. The impact from large inflows and outflows from ETFs will increasingly dominate the behavior of individual assets. This increased price noise will reduce price discovery and create a less healthy market infrastructure. Investors should prepare for these changes with what I will call ETF shock plans.

Momentum - Not an anomaly but just "normal" behavior

“There are patterns in average stock returns that are considered anomalies because they are not explained by the Capital Asset Pricing Model…The premier anomaly is momentum.” Fama - French "Dissecting Anomalies " Journal of Finance 

Many now agree that momentum is not an anomaly but a core risk premium strategy whereby investors receive excess return for following trends either through time series or cross sectional models. It is not an aberration that will go away through better modeling or through identification.

There are a number of reasons for why momentum will work, from behavioral arguments about slow adjustment, under-reaction and then over-reaction, to being paid as an offset to the risk of crashes from herding. A slow speed of adjustment based on behavioral biases seems to fit data and in spite of our knowledge will not easily go away. Additionally, in an uncertain world, cautious behavior is the norm as investors seek confirming evidence. Many arguments are suggestive, but the rationale for trends is still a work in progress with competing narratives. Momentum occurs because there are frictions in markets that run from behavioral, informational, and structural. Nevertheless, it does not change the fact that trends and momentum are the most consistent risk factors measured through time. Frictions do not stop markets from reaching their destination but slows the process which leads to opportunities for those that follow price dynamics. 

The momentum factor, both cross-sectional and time series, has shown long-run return consistency. Yet, long-run consistency does not mean that money will be made every year or that there will not be periods of significant under performance relative to other risk premiums. Poor momentum performance today will lead to futures positive performance tomorrow as this style loses popularity. A time varying risk factor cannot be confused with an anomaly 

This does not mean that momentum trades cannot be crowded, but the underlying nature of trend and momentum makes crowding difficult. Too many investors engaging in a trend trade will not cause trends to disappear. Rather, too many investors will cause the trend to move faster to some equilibrium with the potential to overshoot and then reverse. Slow traders who follow long-term trends will under-perform but faster traders with shorter investment horizons may outperform. Time-frame switches lead to under-performance for the single time frame static trader. This time-frame dynamic is one of the key challenges for any follower of momentum. Crowds change trends and require time-frame diversification. Research shows that momentum will not always be the same. 

Similarly, the behavior of one market will not be the same as others. Structure, costs, liquidity, and the mix of market participants will change the characteristics of momentum but not eliminate the factor. A given market will have its own time varying momentum returns. These aggregated returns across all asset classes show positive returns. Momentum is not a anomaly but part of a market process where returns associated with price dynamics ebbs and flows.

Credit risk premia and credit spreads - These are not the same

Specialized investing in credit risk premia is large and growing market but there are some simple definitions that will help with any discussion about rich and cheapness of premia. Most credit investors will analyze current spreads versus historical data and make a determination of whether they are being paid for the credit risk being taken. However, there is more going on if you truly want to get to the true credit risk premium. The real question is whether the risk premium received is enough to offset the risk of default and downgrade. These factors change with business and credit cycle. Spreads should reflect these risks, but there can be divergences between market prices and actual risks.

The true compensation for risk should account for the loss from a default and the loss from a downgrade. The downgrade risk can be measured through looking at transition matrices which track the likelihood of a downgrade over a time period versus the cost of a downgrade as measured by the differences in spreads with different ratings. The risk of a downgrade will change across the business cycle. If there is an expected recession, then there will be a highly probability that there will be a downgrade. Similarly, if there is economic improvement, there will be a greater likelihood of an upgrade in ratings.

A similar analysis can be done for the risk of a default. An investor needs to measure the likelihood of a default as well as the recovery value from a bankruptcy. The difference between the market price and recovery price will determine the size of the loss. Default probabilities will also change with the business and credit cycle. Hence, OAS spreads, as the weighted opinion on these credit issues, will change with the business cycle.

These credit issues are discussed in the white paper, "Where Has My Credit Premium Gone? A Perspective on the Current US Corporate Bond Market by Mellon Investment Management".

Many investors believe that the cost of downgrade and bankruptcy will be incorporated in the OAS spread, but a closer look at the data show that OAS spreads and credit risk premia are not perfectly correlated. As credit risks increase, there will be a corresponding increase in spreads as seen during recessions. This should be expected, but the difference between what is priced in the market and what is the likelihood of these risks being realized may not be the same. Any discussion of credit risk premia has to look at all of these factors to make an effective judgment on whether there is value in this risk premia.