Low volatility a mirage
Simon Doyle says that investors need to remember that low volatility doesn't mean low risk.
September was a mixed month in financial markets. While it began poorly for many assets, the second half saw many of these trends reverse. The initial weakness was largely due to sentiment that monetary stimulus is reaching the limits of its effectiveness and the policy mix (at the margin anyway) could change. Such thinking, however, dissipated after softer US data gave the Federal Reserve another reason to balk at raising the US cash rate. While bond yields rose early in the month, much of this was reversed. While the Australian equity market edged higher in aggregate, significantly sectoral divergence emerged. Materials posted solid gains (+5.6%) while REITs, telecoms and utilities recorded declines (-4.3%, -4.0% and -3.6% respectively). The vulnerability of the “bond-sensitive” sectors has been a dominant theme for us for some time (particularly against the relative cheapness of commodity producers). Being positioned for this shift contributed to performance in September.
Notwithstanding the comments above about market performance in September, volatility in financial markets remains low. A naïve assessment would be that risks are also low. After all, relatively narrow credit spreads and moderate prospective returns from equities would seem consistent with this – no?
A more objective assessment, though, would likely conclude that this is not the case. As the recent poor performance of REITs would highlight, if the crutch of central-bank largesse wobbles significant repricing is likely. Owning risky assets because the alternative offers effectively nothing while assuming unwavering central-bank support is not necessarily a sustainable long-term investment strategy. A low return on cash is better than a negative return from bonds. In an environment where risks seem skewed to the downside, it may not take much to cause investors to rethink. Low returns at least imply capital preservation (at a minimum) and the liquidity to take advantage of opportunities. This optionality is not without value even if in the short run there might be an opportunity cost.
The list of reassessment triggers is long; and history suggests that in all likelihood the trigger is not even on the list. European banks (Deutsche Bank is currently prominent), a Trump presidency (not the base case but neither was Brexit), the Chinese debt bubble or a pick-up in US inflation each have the potential to shake investors from their complacency. Focussing on triggers, though, while an interesting exercise, is in many ways pointless. The key issue is whether or not the preconditions exist. On this point asset prices are vulnerable.
A disconnection exists between the pricing of risk and the inherent riskiness of asset classes. At the heart of the issue are sovereign yields, which have been manipulated to satisfy policy goals, not to balance the demand and supply considerations of investors. As this drives the discount rate applied to all financial (and non-financial) assets, prices have risen across the curve, not because the cash flows generated by these assets have improved (either in quantum or stability), but because they are being discounted by a lower number. If yields stay low AND cash flows continue as assumed, then all is good. But if either of these assumptions is tested, watch out.
Secondly, low yields have distorted the behaviour of investors looking to increase income – after all, for most investors their income requirements haven’t fallen with yields. While typical of “late-cycle” investor behaviour, alternative investments have gathered favour. Alternatives are typically characterised by factors such as leverage, the absence of mark-to-market pricing and a lack of transparency in the underlying investments (and performance fees). While their introduction may help smooth returns when markets are kind, they can compound the challenge faced by investors if markets conditions worsen. (The year 2008 is a good case study). Liquidity should not be undervalued.
We probably sound like a broken record on some of these issues but so be it. Timing, as always, is the difficult bit. Trying too hard to finesse this, though, can be just as problematic as not being positioned in the first place. To this end, we have maintained a consistent position with respect to the growth-defensive split in the portfolio. Our equity exposure is about 28% (but drops to 23% if we adjust for the delta of a put option position should markets slump). The flip side of this is a cash holding of about 26%. During September, we introduced a small (2.5%) exposure to an absolute-return emerging-market debt strategy, in part by trimming our high-yield credit exposure. This should not be read as us turning bullish on emerging-market debt, but rather that we were looking to diversify some of our corporate exposure in a low-risk way. Overall, we remain cautious.
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