February offered investors a glimpse of what could happen if economic conditions and policy slightly shift on their respective axes. While our returns were not spectacular in February, they were positive against a backdrop of some large falls in equities (while global equities declined around 3.5% during the month, intra-month declines in some markets were in the order of -10%) and wider credit spreads, mainly in the high-yield space. This served as a timely reminder that risk does matter, and certainly from our perspective in managing the strategy, avoiding/mitigating drawdowns is an extremely important objective. While we acknowledge that our returns would have been better in 2017 if we’d held more equities, this is a double-edged sword. More equities are fine on the way up, but punitive on the way down, and, while we’d like to think we can time markets, the reality is we can’t. February showed what can happen.
While the saying “be careful what you wish for” has plenty of merit, it’s fair to say we weren’t unhappy to see a return of volatility in February and at least the partial recognition that the outlook was unlikely to be as positively benign as market pricing had suggested. Opinions vary in the market as to whether the sharp decline in risk asset prices was a ‘technical’ correction – given the extent to which short volatility trades had been piling up — or whether it was more fundamentally linked to concerns about US inflation and the path of monetary policy. The net result was a short but relatively sharp shift in asset prices, mainly felt in equities.
While the world is not markedly different to what it was a few months ago, there are some things that have shifted.
Firstly, the evidence is continuing to accrue supporting the idea that core inflation is starting to rise in the US and that this is increasing the uncertainty around the future course of monetary policy. Bond yields have reflected this with US 10 year bond yields rising around 0.5% so far this calendar year. The latest pronouncements from the US around steel tariffs and trade wars have also elevated uncertainty around trade, retaliation, and by extension, growth. While US President Trump’s constituency may be buoyed by the protectionist rhetoric, it may ultimately end up as an “own goal”.
Secondly, while economic conditions have been good (decent growth, improving profits, low inflation) and the US tax cuts a clear pro-cyclical boost to growth and profits, the exponential rise in equity prices through the December-January period was an over-exuberant response leaving both sentiment extreme and valuations extended. While some of this over-exuberance has been reversed, the shakeout to date has been relatively moderate. Valuations have adjusted, but not by much. The medium-term outlook for both bond and equity returns still looks poor.
Thirdly, some of the complacency evident in markets and reflected in the exceptionally low levels of market volatility has rightly been shaken-off, offering a timely reminder that complacency can beget disaster as investors in Short VIX futures ETFs can attest. These funds, that attracted reasonable flows in 2017, have now either collapsed completely or are trading at prices 90% or more below their peaks. Volatility is unlikely to return to its recent lows.
To be clear, we believe it’s premature to call the end to the bull market in equities just yet as most bull markets end with recession, and the risk of recession in any of the major economies at present is low. That’s not to say a policy mistake isn’t possible, or, as we’ve noted above that something like aggressive retaliation to US trade pronouncements couldn’t sap confidence and derail the global growth trajectory. More likely we think volatility will remain higher than 2017, returns overall will moderate and uncertainty about policy and the economy will re-exert.
While we are well positioned to add risk to the portfolio, we are reluctant to rush in as the retracement in equity prices so far has been relatively modest. Volatility will likely provide us with some opportunity, but volatility to date has not fundamentally shifted the risk skew.
That said, we have made a couple of changes to the portfolio.
We have continued to build the inflation risk thematic into positions via duration, inflation break-evens, inflation-linked bonds and our short A-REITs positioning. This positioning is now significant, and we are unlikely to add materially to this unless our concerns about inflation rise further.
We have also moderated our long GBP position amid renewed uncertainty around Brexit and the UK government. This is a short-term risk reduction trade and one we expect to reverse given the medium term attractiveness of GBP on valuation grounds. This fits with our overall thesis that US dollar weakness won’t be sustained in light of the US now being one of the world’s high yielding currencies.
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