Managed futures turn negative on the renewed interest in the "reflation trade"

Managed futures returns across CTA's were down on average for September based on reversals in currency and bond trends. The weakening dollar and the strong bond returns during the summer made for good performance in July and August, but the combination of renewed interest in the Trump reflation trade and uncertainty concerning the direction of interest rates changed the trend opportunities.

Unfortunately, for a trend-based manager, there will be a giveback of some previously accrued profits. Signal identification for exits and new positions is based on price reversals, so changes in directional slope will see negative portfolio returns. Some firms will be better at signal extraction based on the time frame for trades and the any conditional factors, but all will usually see a profit cut. This decline is more pronounced when there are sector changes and not just market adjustments. Given bonds and currency are large sector exposures for many CTA's, the negative returns should not be surprising. 

Managed futures and bonds are strong diversifying assets through their low correlation to equities. A strong equity (risk-on) environment will not be good for "bad times" portfolio diversifiers. There is a cost with diversification. 

No "inflation mystery" with equities but bonds more uncertain

Regardless of the speculative warnings or the beware signs in fundamentals equity markets continue to move higher.  Who says there isn't inflation? It is just a matter of definition between real goods and financial goods. 

This month small cap, value, and growth benchmarks led sector returns as plans and talk of tax reform and/or cuts are back on the table. The continued cautious Fed announced their balance sheet normalization plans which will start next month, but it will take years before there is a real serious dent in the Fed's balance sheet. Nonetheless, other central banks continue to expand their balance sheets and provide liquidity. The Fed also engaged in further talk of gradualism since inflation continues to fall below the 2% target. Without a negative catalyst and no binding constraint on credit, the markets move higher. 

Bonds posted negative returns on asset class switching and the uncertainty concerning inflation. With Fed chairman Yellen speaking about the "mystery" of inflation, there is more bond uncertainty. Bond risk premiums, which include inflation uncertainty, have been squeezed to zero, so anything that causes market confusion on the link between Fed policy and rates will boost that premium and be bad for bonds.

International investments were mixed based on the   strength on the dollar. Clearly, the stronger relative performance of US assets was from greater sensitivity to fiscal tax policy and a focus beyond the economic noise from hurricanes. 

When markets do not behave in ways consistent with fundamentals there are only two options, avoid the game and focus on risk conservation, or follow trends under the simple view that price action is a better barometer of market opinion. Whether the story for equity strength continues is not clear; however, the cost of risk avoidance has been high in 2017.

Asset allocation dispersion risk - The cost of wrong allocation picks is significant, so you need macro gamma

There is no question that research shows that asset allocation matters. It matters more than stock selection and it matter more than manager selection. But, it is sometimes hard to visualize what is the impact of different asset allocation choices. The following table from Fidelity's Market Snacks is enlightening.   The table of average annual return is completely expected. If you increase risk through more aggressive asset allocations, return goes up. The movement from conservative to aggressive over the long-run is linear; nothing new here.

However, if you look at the risk as measured by the best and worst year, or the best and worst fifteen-year period, the impact of investing at the wrong or right time is stunning. Holding an aggressive portfolio at the wrong time is very costly while being aggressive at the right time is very profitable. Any change in the asset allocation mix can have a meaningful impact in both the short- and long-run. Some investors may respond that since predicting the market environment is so difficult, dynamic asset allocation should not be tried. Investors should look at their risk profile or point to the life cycle and that should be enough for making long-term decisions. 

An alternative view to the problem is that more aggressive allocations need to be matched with more aggressive downside protection or active switching across asset classes. Portfolio protection and risk-taking should be taken through diversification to specialized asset managers who can adjust more quickly global asset allocations than most investors. 

We believe that this is one of the chief reasons for holding global macro and managed futures. Managed futures will provide for better downside protection during those times when the market is in turmoil and there is a chance for a large market decline. The manager can switch exposures quickly through trading futures both long and short.

There is a need for downside protection and also more upside potential when there are large market divergences. Managed future will provide positive convexity or gamma within a macro portfolio. Of course, convexity and downside protection may come at a cost, lower stand-alone returns when the markets are calm. Consequently, some of high returns from an aggressive allocation can be used to pay for the lower returns from managed futures during good times. In exchange for this asset allocation strategy diversification payment, the large dispersion in downside returns in the short-run is dampened while still allowing for upside divergences. 

Deloitte CFO survey - Overvaluation and less optimism - Beware

The Deloitte CFO quarterly survey should give any investor pause for concern. The numbers for this quarter show that 83 percent of those surveyed believe the equity market is overvalued. The number is at all time highs but has been around 80% all year, in spite of the market continuing to go up. Perhaps the CFO's forecasts are wrong; however, I have more concern from the economic sentiment and expectations.

Economic optimism for North America is declining. Company specific optimism is also falling. Revenue and earning growth are moving sideways. The only real positive is European economic optimism and to a lesser extent domestic personnel growth. The combination of overvaluation and less optimism should make any market correction more likely.

As we begin the fourth quarter, the survey suggests that plans for more defensive asset allocations should be pushed forward with less delay. Now, the tax plan that many have been hoping for has shown some signs of life since the survey, but its complexity suggests that, at this time, it will not change the current CFO sentiment.