It is a common refrain that, in a crisis, asset price correlations move towards 1. What was once independent is no longer so, as a large common driver has emerged creating large and often forced flows from leverage unwinds and VaR models that then feed on themselves. This is shorthand – what really happens is correlations move to extremes.
Over the past 40 years or so, generally speaking, stocks and yields have been positively correlated. There were a couple of short-lived hiccups around the taper tantrum and early 2007 which soon reversed. In previous periods of stock weakness, you can see the correlations move decidedly higher.
We aren’t the first to write about this being the foundation of most portfolio allocations. Yields drop and bond prices go up. A positive carry reliable portfolio diversifier- the holy grail to those that practice the dark arts of optimization. We also aren’t the first to point out this has been made possible due to generally low and steady inflation, meaning in periods of crisis or economic weakness it has been fairly easy for central banks to ease policy, underpinning the correlation. This chart from Goldman Sachs illustrates this.
Risk parity portfolios are an example of this type of construction. Sometimes they add in other asset classes as well – credit, REITs, commodities etc. One drawback as we see it: they are long only. When correlations move toward 1 in a crisis, and you are constrained long only, you only get to choose from one side of the return distribution; you need the asset to go up. Managed Futures have shined in previous periods of crisis, and done well as an equity market diversifier, by capitalizing more fully on the correlation moves. They allow exposure to the big negative correlations also, and in more places than investors typically have exposure – like currency markets. To our eye this is a huge improvement over long only methods of portfolio construction, and why we think Managed Futures strategies warrant a place in all types of portfolios.
Take crude oil for example. In a crisis, correlations move to extremes. Sometimes that correlation is near 1 like in 2008 as crude as crude collapses alongside stocks. Sometimes that correlation is near -1 as in early 2022 as crude gained and stocks fell. You need the short side of markets to capture the broadest range of moves to correlation extremes that you can. Managed Futures, in a crisis, hones in on the big flows and macro uncertainty that hurts equity markets whether those moves are caused by other markets going up or going down. 2022 is a great example of the need for both long and short exposures. The stock markets prime concerns in 2022 have been soaring commodity prices and collapsing bond prices. Strategies that rely on only the long side are at a disadvantage.
(PS – Couple of smaller points – on Managed Futures execution, it helps to do another couple of things under the hood, which we have written about in the links that follow. First, when Managed Futures are locked in to diversifying positions in a crisis mode – hold on. Don’t adjust positions just when the volatility picks up. More here. And second, stick to major markets. It is those that cause the systemic issues or capture the biggest crisis flows. More on that here.
Here’s a fun chart one of our colleagues spotted. On August 30, 2020, Salesforce replaced Exxon in the Dow. The following chart shows the total return of each since the change:
We realize the keepers of the Dow want to stay up with the times, but it’s not like Exxon was going out of business.
We can find no better argument for an allocation to value stocks. Valuation is often driven by fashion. I seem to recall that, at the height of the pandemic, Zoom had the same market cap as Exxon. Fashion. Style. The key thing to remember about stocks is that no one needs to own them, demand is completely elastic. Unlike, say, commodities, the price of a stock is not part of any practical business decision beyond capitalization. In simple terms, that means they can trade anywhere and anytime. It also means that value managers must buy things that are often wildly out of fashion, not our natural human tendency.
So, break out the leisure suits, the big lapels, and the super wide ties, and buy some value.
The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.
Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.
Intervention is like trying to hold 100 ping pong balls underwater at the same time – sooner or later one will pop up. As long as the BOJ keeps interest rates artificially low and continues yield curve control, the currency will eventually, intervention or not, get blasted. When the Fed is guiding market yields close to 5% and even the Europeans are raising 75bps a meeting, the policy gaps are untenable. Something has to give. As we write this, the BOJ is intervening again – they moved the currency about 1 percent, and then it immediately sold off again.
So why is the BOJ doing this. Japan is by far the most indebted major economy. That was fine as long as rates were low. What changes that calculus is – you guessed it – inflation. Unwinding these policies is like landing a jumbo jet on a football field. As the now ex UK PM Truss found out, the room to maneuver can shrink pretty quick.
The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.
Right now, moves in the stock market are being determined by moves in the 10yr Sterling bond, the gilt, and as the LDI debacle unfolds and spreads into other markets. Gilts down, stocks down. All concentrated managed futures portfolios would trade the gilt, and would be short. However, if your fixed income portfolio trades a zillion different bond and interest rate contracts, the impact of that gilt short, and its diversifying character, would be diminished. It’s highly unlikely that something that happens in Sweden or Thailand would have the same impact as something that happens in the UK, a major money center. It’s the major things that cause major problems in equity and credit markets. A more concentrated managed futures portfolio is likely to have more exposure to those major drivers.
This problem gets compounded by the desire of quants to “risk adjust”. In the current environment, risk adjust means cut the gilt short because volatility has gone up. That may risk adjust for the manager, but not the holder of the broader portfolio. He now has less participation on the source of market volatility. We’ve written more about how that looks in a portfolio here and here.
Remember, what’s good for the manager’s Sharpe ratio may not be good for your portfolio Sharpe ratio.
2022 has been an awful year for most all assets. Through the end of the 3rd quarter, the S&P 500 is down 23.9%, High Yield bonds down 14.4% and Investment Grade bonds down more at 21.2% (worse than HY due to the longer duration in IG). Over the past few decades, investors have been somewhat accustomed to seeing US Treasuries do well in tough times for equity and credit markets, this year though, 7-10 year US Treasuries are down 15.7%. It’s an ugly scene…not a lot of places to hide.
One bright spot – Managed Futures strategies. We wrote about these earlier in the year here. Our long-held view is that Managed Futures are fantastic portfolio elements. We like them more than most – and execute them in a purer form than most as well – but recognize them for what they are. A Portfolio Element. Most investors, us included, hold portfolios of stocks and credits. To our eye these are also Portfolio Elements. Stocks tend to do well in times of economic stability, growing earnings and rising multiples. Managed Futures tend to do well in periods of macro-economic uncertainty and instability. Combining these two elements makes a lot of sense to us.
As with all portfolio construction, the only thing more important than having a plan is following a plan. Rebalancing is plan-following in action. In the years prior to the pandemic, it had been a fairly fallow period for trend following strategies. Continuing to hold exposure to portfolio elements that are out of favor for a period is not easy to do. A lot of investors start with a great portfolio of undiversified elements, then at the end of every year take a look down the list of line items and chop the bottom few. If you do this a few times in a prolonged cycle, you end up with quite a correlated book – whether you notice it or not. This happened pre 2008 when both energy stocks, emerging markets, commodities and carry strategies were all doing well. If you aren’t careful and you chop the other pieces as they underperformed and didn’t rebalance the winners, you end up with a chunky overweight in those things. As that cycle continued it became fairly clear the drivers were narrowing. Commodities were going up, which helped energy stocks. It also helped emerging markets, which at the time were more heavily raw materials based economies. Hot money flows into the markets amplified the FX component of the returns too, and in currency carry the commodity currencies were outperforming and had higher rates. They all unwound together.
Fast forward to the past couple of years. Tech has been doing incredibly well – fabulous business performance, network effects, buybacks and multiple expansion. Venture capital had been doing well. The broader stock indices became more concentrated along the way, and low rates seem to boost steady subscription type businesses and REITs. We have a common factor forming. The cycle extends and credit spreads tighten, borrowers extend and refinance into new bonds at lower coupons, increasing duration and reducing risk premium. Government bond yields got lower and lower, as they were the perfect component – uncorrelated to negatively correlated positive carry hedge. Managed Futures allocations…some folks maintain in dollar terms, others reduce or cut it, or don’t rebalance into it, letting the weight drop.
This year so far, when everything else has been getting hit as the common Achilles heel – inflation – rears its ugly head at a time when with hindsight, stocks and bonds were priced for perfection. An ugly war in Europe didn’t help either. The definition of macro-economic uncertainty into markets that were priced for stability. Record high SPX at a 23PE, a US30 year yield under 2% and high yield spreads at just 3% – less than most estimates of full cycle default rates. A rare bright spot in a sea of tough market returns? Managed Futures.
Interestingly, at least to us, is the reason why. Managed Futures tend to have commodity exposures, fixed income exposures and currency exposures. Some do stock as well. All instruments that tend to shift with the macroeconomic uncertainty. They don’t tend to do individual stock or credit picking, these are large global macro markets. Inflation impacts all of these. Commodity prices up in the first part of the year helped a lot – oil markets and grains. Short positions in fixed income as bond yields rose across the globe. Currencies are maybe the most direct expression of macro and were large contributors. The Euro fell hard driven by relative interest rates and growth trajectory impact due to proximity to the geopolitical situation. The Bank of Japan continues to maintain ultra loose monetary policy settings through a 25bp 10-year yield curve control policy at a time when the US is raising the front end by 75bps every meeting. The Japanese Yen moves abruptly lower. We show a few of these market moves in the postscript below. Managed Futures has exposure to each of these moves. The uncertainty hurts equity markets, Managed Futures diversifies uncertainty.
So where do we stand now. Well one reason you do different things in a portfolio is that when one set of things is struggling and another is doing well, you can rebalance along the way. Use the gains in Managed Futures to buy stocks and credits when they are more reasonably valued. 2008 was a great example – stocks fell 37%, CTAs had great years. The years after were reversed, with stocks making 26% in 2009. Rebalancing the CTA gains meant one could use the gains to buy equity at lower levels. One has to decide the timing – truth be told it doesn’t matter too much, as long as you do it. Annual maybe a little too infrequent, quarterly or monthly seems about right to us. And if they haven’t moved a lot relative to each other, maybe it’s not worth it and a rebalance threshold approach is more reasonable. That’s fine too. Examples of what this would look like are below – monthly schedule when they have moved a chunk. Rebalancing the CTA as it goes up, and buying equity like clockwork. No fuss, no panic.
If you don’t have exposure to Managed Futures in a portfolio, maybe consider if it makes sense as a way to get exposure to a different return stream that often benefits from uncertainty, in a way that fits your goals. If you already do have exposure and it has performed well while other things haven’t, and the allocation has naturally grown through those performance differences, consider rebalancing. Now timing this is next to impossible. But picking a time, rebalancing mechanically like clockwork is important. If you have a good portfolio plan, follow it.
Below are examples of moves that have worked in Japanese Yen, Crude Oil and US 10YR Notes, respectively.
The idea of investing quadrants has been around a long time. Divide the potential environment into 2 planes, basically growth and inflation. Determine the current intersecting box, invest in the things that have done well historically in that box. It’s a great shorthand method of putting order to chaos, most of the time. Thought experiment … Is the economy growing? Real GDP is negative, so no, nominal GDP is on fire, so yes. Weekly unemployment claims are low, so yes, but job openings are falling, so no. You get the point – picking the box is tough. We are in a really inflationary time, so buy gold, right? Wrong, regardless of what the cable ads say.
Check out this chart:
Earnings expectations have fallen, particularly ex-energy, as the market factors in a recession. Strange recession where energy companies are the leader.
We prefer to let price be the guide. It’s no surprise that when researchers looked at a vast array of possible variables that drive AI investment decisions, momentum clearly dominated all other choices (OP-REVF200009 (chicagobooth.edu)). Our preferred method is trend-following. If you boil it down, trend-following is simply a robust method of identifying an unobservable state variable (fancy, huh). Am I in a bull world or a bear world, across a wide range of markets. It’s not locked into a pre-defined set of relationships. An overused quip is of use here – history doesn’t repeat, but it rhymes. Use trend to get the beat.
Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.
The current situation. UK pension funds (BPM in this case) have a problem. On paper, falling interest rates lower the discount rate on the future liabilities of the fund. Makes the fund look bad. Can’t have that, say LFI. We will buy a leveraged position of long duration bonds. As rates fall, the increase in liabilities will be offset by gains in the long bond portfolio. If rates begin the rise, the losses on bonds will be offset by paper gains in the reduced liabilities. Sounds good, or as Dire Straits crooned…Money for Nothin. This will work fine, as long as we don’t get a real fast inflationary spike in rates, which of course we won’t because we know inflation is dead. Whoops…
Rates spike, liabilities do fall on paper, but the margin call on the bond long requires real money…right now. A classic liquidity mismatch. All of a sudden, pension funds have a margin call. On this latest yield spike, the central bank has to intervene in the name of financial stability. Liquidations spread to other markets as the funds scramble for cash. Normally history doesn’t repeat exactly, but rhymes. In this instance though, it’s closer to a straight rerun. This happened in Orange County, CA in 1994 when rates rose, and it’s literally used as a finance case study on risk management and what not to do. And yet here we are, just far enough along for a new generation to make the same mistake.
Rule 1 in finance…keep it simple.
Postscript – October 11, 2022
The FT has published a fabulous piece on the episode at this link (paywall). It fills in the BPM and LFI cast of characters and has some great quotes – turns out our read was pretty accurate all told…
As they made their pitch to overhaul the pension scheme of one of Britain’s biggest retailers, Next chief executive Lord Simon Wolfson remembers the consultants were “very sure of themselves”.
“Liability-driven investing”, the consultants promised, was a stress-free way to protect the fund from swings in interest rates by using derivatives.
There is one particular phrase that still sticks in Wolfson’s mind from the 2017 meeting: “You put it in a drawer, lock the drawer and forget about it.”
“The speed and the scale of the move in the gilts market was unprecedented,”
“The crunch event was not in anyone’s models,”
But even he acknowledges that its complexity is an issue, with tricky collateral management and an orchestra of instruments from gilt total return swaps to gilt repo and inflation swaps. “Undoubtedly the problem is that people don’t really understand it,” he said. “It’s like trying to explain some aspects of quantum physics to people who aren’t really physicists.”
…pension schemes in aggregate will have to come up with as much as £280bn to fully recapitalise their interest rate and inflation hedges with new lower levels of leverage. This is in addition to the £200bn that schemes have already had to deliver to meet LDI collateral calls…
When you woke up yesterday morning, this was the headline of the lead story on Bloomberg News:
The past week had been really tough, with bonds and stocks both crushed, regardless of locale. There were panic moves everywhere, but particularly in sterling. Third world type emergency action being considered to control the slide. If the Fed’s mission was to break something, well, mission accomplished. Negative skew everywhere. There was, almost, no place to hide.
Almost because there was one place to hide, a well known asset class that advertises success in periods of adversity and volatility. An asset class that exhibits positive skew, or as my partner likes to say, it crashes up. An asset class that is up this year, and up this month, yet is not particularly dependent on manager skill. Simple Alternative Beta indexes capture the returns nicely. Its liquid and easy to access in a variety of formats.
What is it, you say? Its Managed Futures, of course. Now let me warn you. There will come a point when the markets will settle down, Darth Powell will take his foot off the brake, and traditional assets will recover. Managed futures will likely give back some recent gains, perhaps with a vengeance. But if you had it in your portfolio, the profits you gained could have been rebalanced into those cheap equities and credits, primed for the next move higher. It’s a beautiful thing, but you need to be in the game to win.
Here’s a question in everybody’s mind – Have we seen the top in commodity prices? We can see both sides of the argument.
Yes. The Fed is going to move far enough to break things, that will push us into a recession or worse, and commodity prices fall in recessions. It’s global too, with Europe and Japan falling out of bed. China won’t come to the rescue this time either, with the Ponzi bubble that is China real estate deflating and Covid lockdown mania. With the USD on a tear recently, for those overseas buying things priced in USD it’s even worse. Oil in Europe and the UK is through 2008 spike highs already, demand destruction ensued then and will now. Forget it, the commodity trade is over.
No. Virtually every commodity, from grain to oil to electricity to butter of all things is tight.
One great example, beef. Beef is one of the few commodities that has risen very little over the last year. Why is that, you ask. Because US ranchers have been liquidating the herds and putting that beef on the market, as costs have risen. That has kept near term prices lower, but if the economy recovers, the herd will not be rebuilt fast enough and prices will rise rapidly. A classic whipsaw, and it’s happening everywhere. Prices have risen because of supply issues, and raising rates will not help supply as it raises the cost of production. Should the Fed take its foot off the brake, supply will not be replenished fast enough to satisfy instantaneous new demand. Result – higher prices, a bit down the road.
Last week we said – watch rents. Look at this chart. If we have seen peak hawkishness, get bullish commodities.
The reaction to last week’s CPI print was pretty dramatic. We see a couple of related factors:
Given the fall in gas prices, the S&P had bumped off the bottom in anticipation of a soft print. Positioning went from negative to perhaps modestly positive. CPI caught the market on the wrong foot.
Gas prices as reported in the CPI did fall as expected, but just about everything else went up (see graph below). Everyone knows gas fell because of releases from the Strategic Petroleum reserve. That policy is the definition of “transitory” (they will need to buy it back, no less). With everything else going up, inflation fears pulled a Lazarus.
Watch rents. Lagging but steady inflation indicator, closely tied to wages.