Back for good?

The ECB and the German government added to policy support in Europe this week. This further fuelled the cyclical risk-on behaviour of markets. Returns are positively skewed, and dispersion has fallen. The further this goes, the greater the need to hedge for a set-back (and there are lots of reasons why there might be one). Equities are economically sensitive, long government bonds are interest rate sensitive. They compliment each other, especially in times of stress. Avoiding both but still wanting return, leads us back to credit. Spreads continue to grind tighter. A risk reversal will do less damage to credit because the support that wasn’t there before the crisis, is now.

Whatever it takes 

The ECB announced the intention to further increase its balance sheet this week. Its Pandemic Emergency Purchase Programme will be upsized by €600bn and the central bank committed to re-investing coupons and maturities until it feels that its monetary objectives have been met. Furthermore, the option was kept alive to do more if necessary. If progress is made on the Recovery Fund in the months ahead then chances of a repeat of the debt crisis of 2012 are very slim and sovereign spreads can trade lower still. Remember that Italian bond spreads were as low as 100bp over Germany for the benchmark 10-year bonds back in 2015. In March that spread reached 275bp and is now 175bp. It moves in line with risk appetite and other credit spreads. I don’t want to keep repeating it but the policy position is driving risk valuations higher even though society in general is less economically active, less healthy, poorer and more fragmented than anyone can remember. Italy still has a weak fiscal position but the funding side of it has been strengthened. Moreover, the ECB has reaffirmed its independence. It will do whatever it takes. This remains a huge driver of the cyclical performance of markets and should be taken into consideration in making investment decisions.

The song remains the same

Typically, when we think about strategic asset allocation, we look at the historical returns and volatility of asset classes and strategies and the correlations between them to arrive at a portfolio that is estimated to satisfy the return objectives and risk tolerance of the investor. However, any data series that incorporates the period February-May 2020 will be distorted by the high levels of volatility experienced then. Luckily, the main stories won’t have changed too much as the relative movement of bonds and equities, and the correlation between them, were fairly consistent with the historical record.  The ordinal relationship between cash, risk-free government bonds, long-duration hedges, investment grade credit, high yield and equities remained intact during the COVID-19 crisis. This is one consideration when planning investment strategies for the post-COVID world.

January 

It’s fascinating looking at the behaviour of markets this year. The period between the end of 2019 and February 19th (S&P peak) was defined by positive total returns across most asset classes with relatively little dispersion. Across 64 different asset return profiles covering core government bonds, investment grade credit, high yield and equities for that period, the standard deviation of returns was 2.26 with a minimum total return of -2.7% and a maximum of 9.6%. The principal characteristics of that period were positive economic growth expectations and low interest rates. Risk scenarios had also retreated with progress on US-Chinese trade relations and Brexit in late 2019. It was a benign time for all asset classes.

Sudden shock 

Then the bug hit. Suddenly economic growth expectations collapsed, there were extreme policy moves and risks focussed on a global pandemic. Common factors had polarising rather than unified effects on assets. Risk factors behaved differently and returns became very dispersed. The standard deviation moved to 15.8 and the range of returns was -42% to 13%. This was the relatively short period between 19th February and 23rd March. Strong policy action and the elevation of capital preservation to the key investment objective led to strong returns from government bonds. Everything else was negative.  

Upside skew

Risk then flipped as the principal driver became the view that lock-downs would control the virus and allow an eventual recovery in economic activity. Between March 23rd and May 20th, when the S&P first closed above 6,000 again, things reversed. Dispersion remained high and was driven by the incredible recovery in equity markets and high yield. In that period the standard deviation of returns was 11.2 but returns were skewed to the positive, with the low being just -1% (long duration Treasuries) and the high, 37.8% (S&P mid-cap). This was the period when the policy initiatives got ramped up, authorities started to get on top of the virus risk, and markets gave increased weight to both policy support and future economic recovery.

Convergence 

Since May 20th we are back to a regime of low dispersion. The standard deviation has moved back down to 3.9. Equities are modestly outperforming bonds (-2.6% for long duration German government bonds has been the weakest return stream, +11.8% for the CAC-40 French equity index has been the strongest). Yields within bond markets are converging back from the widest levels they reached in March and this is happening most quickly in the lower rated parts of the bond market. We appear to be back to a phase where common factors are working in the same direction in terms of their impact on risk premiums. These are the massive amount of monetary and fiscal support and signs of economic activity picking up. As discussed in recent weeks, there is a level of discomfort between the risk-on character of this current period when there remain risks around the pandemic, economic activity and the longer-term uncertainties around economic recovery. Yet the strong cyclical rally continues to be fuelled by hopes for lifting lock-downs, higher levels of activity, falling global infection rates and massive stimulus in Europe.

Which sensitivity

The experience of recent months suggests what might happen if the risk recovery stalls or even reverses. This could happen because confidence in the economic recovery falters, political uncertainty increases or that there are signs of second waves of infection. Dispersion of returns would increase again as risk asset returns turned negative. One key lesson is that diversification is important in protecting portfolios when dispersion rises and risk turns negative. They key risk-diversification access is duration versus economic sensitivity. This is a basic law. When economic growth turns negative, interest rates fall. So, assets that are sensitive to economic growth – equities and credit – suffer and assets that are sensitive to interest rates – government bonds – do well. In all major currencies, over the last ten years, the correlation of local currency returns from equities and long duration (10-year plus government bonds) has been negative (-0.4 in USD, -0.2 in JPY, -0.3 in GBO and -0.4 in EUR). That has also been the case this year.

Beta for beta

I come across the argument that low yields in bonds prevent them being as good hedges against risk. This argument seems to be based on the view that yields can’t go much lower and thus bond prices can’t rise to offset any decline in equity prices. However, this ignores the fact that we have negative bond yields and zero has not proven to be any impediment to yields moving lower. What is important is understanding the behaviour of interest rate sensitivity.  It’s no good trying to hedge a high beta economically sensitive asset with a low beta interest rate sensitive asset. Short-dated corporate bonds won’t prove to be much of a hedge against negative equity returns because they are low beta interest rate sensitive and have some economic sensitivity in their credit spread.

Credit still  

Looking at the environment for investors, cash and risk-free low-beta government bonds have low volatility but offer very little return today. The most effective way to enhance the risk-adjusted return is to add credit, both investment grade and high yield. The long-term contributions to a portfolio or greater return for only moderate increases in volatility. I have been advocating increases to credit exposure in recent weeks and this is paying off with solid returns through April and May. The continued increase in central bank commitments to asset purchases and stable interest rates is very supportive for credit markets.

Higher yields provide a cheaper option 

Adding equities to a portfolio quickly increases volatility. At this stage I would be cautious about increasing exposure, or at least without the consideration of some long duration hedge. Bond yields have moved higher in the last couple of weeks, reflecting the general risk-on environment. However, there is a limit to how far this can go. The near-term news on inflation is that it is lower. The increase in levels of activity are not surprising to the upside. Central banks are still buying. Admittedly, there has been a lot of supply and that may be causing some re-pricing on the books of the primary dealer community. Yields on the benchmark US Treasury 10-year bond have moved higher by 15bps in the last month and by slightly more in the UK and Germany. They are well above the policy rate and thus provide some interesting carry opportunities and maybe entry points for those investors that are underweight in duration in a phase when markets may struggle to perform much better.