As our friends up north returned from their summer holidays, they managed to spread their good vibes throughout the markets, restoring calm and tranquillity to asset prices. Despite a slew of negative headlines and heightened equity market volatility during thin trading in August, September saw the VIX decline, bonds walk back some of their more bearish pricing and equity markets pushed on to retest their highs. Global equities delivered almost 2% in USD terms in September, but this tranquillity was only evident on the surface. Below the positive average index returns was a churning that was only felt by those deep enough within the market.
From hedge funds to money markets, different stress points appeared to percolate. What some are referring to as “Quant Quake 2.0” saw the value factor outperform the momentum factor by 12% on 9 September, a seven standard deviation move. That not only hurt market neutral factor managers but anyone with an overweight to growth stocks, which seems to be most investors. A week later any money market manager would be bemoaning the “Repo Crisis”, where the overnight repurchase agreement (repo) rate jumped from around 2.5% to 10%, a 42 standard deviation move. A daily jump of this magnitude has not been seen since the depth of the financial crisis, when interbank lending dried up as banks no longer trusted each other. Fed officials were quick to highlight how uninteresting this was, then throw over $200bn of liquidity into the system to try and restore calm.
While many technical reasons led to this shock, we tend to worry more about the longer-term structural shifts that contributed. Dwindling bank reserves from quantitative tightening (QT) and increased regulation (Dodd-Frank and Basel III) are squeezing bank balance sheets. This makes bank capital expensive; therefore it needs to be fully deployed, meaning it takes time for banks to unwind and redeploy to arbitrage opportunities such as this. Furthermore, deficit spending has led to a drastic increase in treasury issuance, which thanks to high hedging costs for overseas investors, has shifted the burden from the domestic banking sector to finance. This has caused a USD shortage domestically. Unfortunately, just stopping QT isn’t enough.
Organic US banking growth (roughly in line with GDP) plus the continuing growth of currency in circulation means that reserves will continue to dwindle even if the Fed stops tightening its balance sheet.
While we do not believe the recent repo stress is a symptom of GFC levels of mistrust amongst banks, it does highlight the importance liquidity plays in market stability. Reserves at the Fed will need to be created more permanently going forward, either through implementing a standing repo facility or through outright purchases of securities to avoid overtightening (QE4?). Aggressively cutting rates would also help improve the hedging costs for foreign investors, alleviating some of the domestic liquidity stress. Given data in the US is not terrible, it may be difficult to justify at this stage. For now, markets continue to trade at their all-time highs, earnings continue to come under pressure and we are starting to see signs of quant quakes and liquidity shocks.
Our portfolio position
Anticipating a volatile end to a “tranquil” September, we used the market strength to further reduce our equity exposure within the fund by a further 2.5%. We remain defensively positioned after cutting risk over the past few months and increasing our overall sovereign bond duration. We continue to be wary that the virtuous cycle of central bank easing and asset purchases, which has driven yields down and asset prices up, has pulled forward future returns. The risk is now that the virtuous cycle turns to a vicious cycle as the economy slows, earnings come off and liquidity remains scarce. For now, the most likely outcome is increased volatility with little overall direction, which will favour an approach with flexible asset allocation. As the momentum trade perhaps starts to unravel, we continue to favour active stock selection and believe the underperformance of value will abate. While the events of September will likely only be an interesting anecdote, occasionally “nothing to see here” becomes the “writing on the wall” in hindsight. Until we see a more positive outlook on economic fundamentals or a bottoming of corporate earnings, we continue to focus on reducing volatility and drawdowns for our clients, rather than moving further out on the risk curve.
Equity markets delivered a strong September, with the MSCI All Countries World delivering a positive 1.9% return in USD terms. However, this was off the back of a 2.6% fall in August, leading to a slightly negative quarter at -0.5%. Japan and Europe had the strongest month, delivering 5% and 4% in local terms, which helped them deliver the best local returns for the quarter of 2.4% and 2.8% respectively. Australia and the United States both delivered over 1.7% for the month in local terms, but only around 1% over the quarter. Emerging markets rebounded around 1.7% in September in USD terms, but fell more than 5% over the quarter, primarily due to the escalation of the trade war in August.
The fund remains defensively positioned in equities as valuations remain stretched and earnings come under pressure. Within equities we continue to prefer Australia and Japan due to their more attractive expected returns. Given we believe risk assets will see increased volatility with little overall direction, we reduced equities further this month tactically, but will look to add back on weakness.
After yields fell aggressively in August, September saw yields back up across the board as optimism returned to markets. The US 10-year yield backed up to 1.62% from 1.5% in September but remained down 34bps over the quarter. Germany and Australia saw yields back up 13bps in September but remained 24bps and 30bps tighter over the quarter. Italy was one of the best performing sovereign markets, seeing yields contract 18bps over the month and 128bps over the quarter, an 8.6% total return over the past three months. Far right leader Matteo Salvini took a gamble by dissolving the coalition in a bid to gain control of the government. However, an unforeseen coalition between the Five Star Movement and the Pro-EU Democratic Party forced Salvini out, reducing the risk of ongoing tensions with the EU. Credit spreads remained tight over the month. No change was made to our fixed income positioning in September, but we increased our duration by 0.5 years over the quarter.
The trade weighted US Dollar strengthened marginally 0.5% over the month but finished the quarter up a strong 3.4%. In September, the GBP rallied 1% versus the USD after the opposition party rejected a call for an early election and the Benn Act was passed into law, which requires the PM to seek an extension to the Brexit withdrawal date under certain conditions. However, the GBP remained down over 3% versus the USD over the quarter. The JPY fell 1.7% over the month as haven assets sold off, but remains flat over the quarter. The AUD was relatively flat over the month but fell almost 4% against the USD over the quarter, as the RBA continued to cut rates and provide dovish guidance. This led both the GBP and JPY to strengthen 0.7% and 3.8% over the quarter in AUD terms.
We continue to hold positions in haven currencies such as the USD and JPY to help reduce overall volatility. We have a small position in GBP given our longer-term view that the currency offers attractive valuations.
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