Blog Posts — February 14, 2018

Keep Calm and Watch Your Exposures

by Diana R. Baechle, PhD

Should I get in? Should I get out? Now that volatility is up, what should I do?

Is now a good time to jump back into markets? We believe there is reason you might want to wait for the other shoe to drop. Usually, one might think a 5% drop in the market was nothing to worry about. But as we pointed out last month (in this blog post), one of the dangers of a prolonged low volatility environment (such as we have had for several years), is that low volatility is equated with smaller potential losses. Therefore, even a small drop in the market can seem larger. So last week’s market drops, even though small by historical standards, seemed much larger when viewed in the context of the low volatility environment we have been in for some time, and likely caused a lot of pain. 

This pain, and the fact that the dimensions of the losses far exceeded the initial investment expectations, may cause further de-risking across portfolios (i.e., if it can happen to my equity portfolio, it can happen to my other portfolios).  Institutional asset owners do not react that quickly and risk-reduction trades sometimes take days or weeks to be processed. Therefore, more selling as a reaction to the initial ‘unexpected’ loss is likely to follow.

Some say, “don’t worry, the fundamentals haven’t changed,” and that is a source of internal debate at Axioma, too. On the one hand, in the 10 years since the financial crisis, there has been no interest rate volatility to trigger volatilities in other asset classes. That time is over. Central banks have signaled intentions to take their feet off the brakes on interest-rate volatility, allowing rates once more to play their traditional role of setting the volatility levels for all other asset classes. So far, only the Fed has actually eased off, increasing rates several times since the end of 2015. You still have the UK, European, and Japanese central banks to come! We need to look back to before 2008 to appreciate that impact, and many of today’s investors may not have such long memories. 

On the other hand, underlying economic growth is genuine and healthy—in particular in Europe—which should lend some further support to the stock market. If growth remains strong, higher rates and inflation will be a reflection of continued improvement, and not necessarily harmful until a tipping point is reached, at which point companies cannot raise prices any further and debt financing will become more expensive, effectively cutting off earnings growth. At the same time, higher interest rates mean future earnings and dividends are worth less (because of the discounting mechanism), and bonds offer a more attractive alternative to stocks—a benefit they have not offered in many years. But we could remain in the “Goldilocks” phase (an economy not too hot, but not too cold) for a while.

Is inflation really the culprit for the sell-off?
We don’t entirely buy into the argument of growing inflation pressures. For more than 12 months, market commentators have argued that rising inflation—combined with the accompanying interest rate increases—was a sign of robust economic growth. And suddenly this has changed? Last week there were simply a lot more sellers (at any price) than buyers in the market, which is why share prices dropped. It is human nature to look for an underlying reason—maybe a piece of important news—that triggered a sell-off of such proportions (that is, after all, why so many past catastrophes were—questionably—attributed to some mighty, supernatural being). The most important release at the beginning of this drawdown was the US payroll report. The only remotely bit of negative news in that report was the slightly higher wage growth, which may very well have reflected the impact of a higher minimum wages in many jurisdictions. But, ta-dah, there you are, that must surely have been the culprit! It is therefore likely that, at the end of the day, the downturn was just the long-overdue correction after a 14+ month (or nine years, depending on how you define it) bull run that has sent valuations soaring. This is not to say that inflation won’t rear its ugly head, as unemployment rates remain low, it is just not clear that it is an issue right now.

How has the sell-off changed your market outlook?
Valuations were very high and so were volumes, with a lot of people jumping into the markets, including those who may not have had the stomach for the upcoming volatility. Cash levels have been low (4-5%) and leverage was high, so the gun was fully loaded and waiting for something to pull the trigger.  Short-term equity risk had been rising since the end of November, so the underlying market dynamics were already pointing to a higher volatility environment for two months, yet investors chose to ignore that and pile more new funds into the market.  So, while the fundamentals looked strong, the underlying volatility in markets was pointing to a discrepancy brewing underneath.  In the US, statistical model forecasts exceeded their fundamental counterparts. Although the differences (both medium- and short-horizon models showed the discrepancy) were relatively small, they could have been pointing to something bubbling under the surface that the statistical model saw but was not picked up by the fundamental models.

But the commonly given reasons for the drawdown are not really new. Investors have worried about rising interest rates since the taper tantrum of 2013. They worried again each year after that, predicting two or three Fed rate hikes each time. And when fewer (or none) came, they relaxed again. The yield on US 10-Year Treasuries has been rising since December 2016.  Investors sold in 2013 and 2015, again worrying about the possibility that rates might rise. But when they actually did, they forgot that higher rates could become a problem and just viewed the increases (and the Fed’s tightening) as more evidence economies were strengthening.  More recently, US 10-year yields have risen from 2.35% to 2.83%.  Finally, investors now need to invest with the understanding that interest rates are back in the picture when valuing any asset class, and there is now a viable lower volatility option for yield. Risk assets will need to earn their risk premiums, and investors will need a higher level of confidence that they will, in order to justify allocating their hard-earned savings or pension assets to them.

How can Axioma help?
We closely track, write and talk about benchmark risk and its components. But risk is also portfolio-specific, and contributions to risk have changed significantly thanks to recent events (see this blog post).  In addition, the ability for a portfolio to be well diversified has tumbled (see these Weekly Equity Highlights). Since investors cannot necessarily diversify their way out of this volatility, they may need to hedge instead.

The immediate concern for those seeking to measure and manage active equity risk is how the underlying drivers of risk—countries, currencies, industries, style factors and stock specific risk—have changed. For some, especially factor-based investors, the good news is that although markets have been erratic, style factors have actually been behaving as they should (see this blog post).  We advise clients to look at their factor exposures and forecasts for the macro environment, and use stress tests and detailed risk analysis to see what has changed, and whether they are still comfortable with those risks. 

There are steps to take even without running stress tests. For example, if you are expecting more Fed Rate hikes, then make sure to rebalance your portfolio away from stocks that have a positive exposure to the Leverage factor (i.e., over-weight cash-rich stocks, under-weight indebted ones).  If your forecast for the local exchange rate has changed, you can tilt away from, or towards, the stocks with a positive Exchange Rate Sensitivity factor. Higher volatility seems to be here to stay in 2018 (and beyond), so if liquidity can be an issue, make sure you over-weight stocks with a positive exposure to the Liquidity factor, and under-weight stocks with a negative Liquidity profile. For those investors with a longer investment horizon wishing to remain in the market but for whom the current volatility levels is above their risk-aversion, we recommend tilting portfolio away from the Volatility and Market Sensitivity factors as a way to protect their downside risk and weather the storm. We tell our clients that when markets become very volatile and emotional, don’t focus on market data for decision support; focus on style factors, if they continue to remain calm and objective.  Factors can provide a much clearer picture of what is going on, and how you need to rebalance your portfolio, than market data.  At the same time, you may want to reign in your country, currency and industry bets, or at least make sure the expected active return is commensurate with the (probably) higher active risk.

Assuming we get through this period, what should we focus on for the rest of the year?
The key to where we settle down is whether investors believe the Fed and other central banks in Europe and Asia are ahead or behind the curve on inflation.  The big trade we are seeing is that in the past 10 years, as the search for yield drove a lot of investors to dividend-paying stocks, portfolios were over-weight high dividend stocks.  Because market volatility kept declining to new lows (historical ones, in fact, in the US and some other markets), investors could switch from bonds to dividend stocks without incurring much of a risk increase.  This is no longer true and if bond yields keep rising, and stock volatility is back (and it is!), then for a similar yield you will be hard pressed to justify holding on to a riskier asset.  Therefore, to the concerns discussed above, one should add the exposure to Dividend Yield and/or specific industries with market-beating yields.

Valuations have come down with stock prices, but they remain higher than average and still require high earnings and book value growth to justify current levels. The bigger they come, the harder they fall, so investors should watch their Earnings Yield, Dividend Yield and Growth exposures, too.

It bears repeating that conducting detailed risk analysis of your active equity portfolio may help you better understand your performance and avoid some of the speed bumps likely to come.