Risk on or risk off?
The financial crisis and subsequent massive policy responses have dislocated asset markets from economics. Martin Steward attempts to delineate an investment framework to cope with the confusion
"If all economists were laid end to end they would not reach a conclusion," said George Bernard Shaw. Churchill marvelled that putting two economists in a room resulted in three opinions. Right now, it seems, you'd be more likely to get five.
There is no denying things are a bit weird. The massive policy response to the financial crisis has depressed and steepened yield curves, and the resulting fountain of liquidity has sent risk assets skywards. So, while US two-year yields sit at 0.7% (and the three-month flirts with negative rates), and the euro-zone's sit at 1.25%, equity and credit markets just keep climbing. The last time that happened was 1938 - and the following year the Fed hiked rates and sent stocks into a three-year bear market. The world is finely balanced between two major risks: we are enjoying an economic recovery, but nothing like the one that some assets are pricing in, which suggests that risk could recoil when reality finally bites; but if markets do not recoil, pressure will grow on central banks to withdraw support. Is the biggest threat to risk assets the very ‘V'-shaped economic recovery they are pricing in?
"How can it be that risk assets have been roaring ahead, presumably discounting a robust V-shaped economic recovery, while Treasury bonds are holding their own with a bull-flattening bias, presumably rejecting the V-shaped hypothesis?" asks PIMCO's Paul McCulley. "One of these markets is wrong, it is commonly argued. But that does not necessarily mean that one of the markets must necessarily capitulate to the other in the months immediately ahead. And the unifying explanation is simple: the Fed is committed to maintaining ‘exceptionally low levels of the Federal funds rate for an extended period'."
Oddly, then, a serious correction in risk assets will most likely be avoided if the economic recovery turns from a ‘V' to something more like a ‘W' or ‘square-root'. Luckily, that's about as close to a consensus as our roomful of economists can muster.
The recovery we have so far enjoyed has largely resulted from policy stimulus (like the US's ‘cash for clunkers' scheme, which was wound up in August) and the boost to the inventory cycle as companies ended de-stocking (which also peaked in August). Once the rest of the stimulus is withdrawn, the recovery will rely on sustainable household and corporate expenditure. Don't hold your breath.
"Companies are unlikely to want to tie up capital in inventory while there is a risk of cashflow problems," notes Tim Drayson, chief economist, L&G Investment Management. "That's why we don't expect a real period of re-stocking."
Ana Armstrong, co-founder of multi-asset firm Armstrong Investment Management, says that investment is the true engine of sustainable recovery, and that the current level of 11% of US GDP represents a 60-year low: "That lack of investment, unacceptable levels of unemployment, and ballooning government debt will put a lid on the potential for a sharp and significant recovery."
Corporates are not investing because consumers are too busy paying down credit cards - or looking for new jobs - to buy their stuff. Corporates themselves are exacerbating this with aggressive cutbacks. Many of those job losses, especially in financial services and the auto sector, will prove permanent, and rising commodity prices will also squeeze disposable incomes. "If we think of recovery as ‘the return of the feelgood factor', a lot of people at the end of next year will be asking, ‘Recovery? What recovery?'" says Richard Urwin, head of investments in BlackRock's fiduciary mandate team. Those pressures cast a pall over even positive-looking numbers like improved trade balances - "simply a function of a fall-off in the US consumer, resulting in fewer imports," says Armstrong - and, given that the consumer represents 70% of US GDP, they result in a big hole in economic performance.
Can that hole be filled by the developing economies? Unhampered by excess leverage, many have maintained robust growth: the IMF's 2010 forecasts contrasts 1.3% for the developed world with 5.1% for the developing world, led by Asia with 7.3%. They are enjoying the textbook Zarnowitz-style ‘V-shaped' recovery, with inventory re-stocking feeding through to manufacturing, services, stock markets and ultimately consumers via the wealth effect. But those consumers have big shoes to fill: domestic consumption accounts for just 30% of China's GDP, anaemic given global multipliers. SGAM's head of economic research, Michala Marcussen, reckons Chinese consumption needs to increase 20% a year to fill the gap left by higher US savings; it is currently growing at half that rate.
All of which puts a dampener on ‘V-shapers' optimism, but also on the biggest threat to risk assets - full withdrawal of stimulus and rising rates. As PIMCO's Bill Gross puts it: "Raise interest rates with 15 million jobless? All because gold is above $1,100? You must be joking. We will need another 12 months of 4-5% nominal GDP growth before Bernanke and company dare lift their heads out of the 0% foxhole - mini-bubbles or not."
Most agree, despite early signs of ‘normalisation'. "Ben Bernanke has signalled extremely accommodative policy for the foreseeable future - which I would suggest could easily be the whole of 2010," says Neil Dwane, Europe CIO at RCM. St Louis Fed president James Bullard (a potential candidate for the FOMC next year) recently suggested rates might stay put into 2012. Against that, history tells us that the Fed waits about six months after unemployment has peaked before hiking, which might force the end of its "unchanged for an extended period" pledge soon. "We expect the move to higher rates to be relatively rapid," says Investec's co-head of fixed income, John Stopford. "The Fed's gradual approach to tightening from 2004 now looks to have been a mistake, whereas the shorter, sharper rate cycle from 1993 was followed by a long period of more balanced growth."
The UK picture is complex: there have been record-breaking declines in business investment, the labour market has been relatively benign but unemployment continues to rise, consumer spending has held up surprisingly well, and while the economy continues to contract, inflation has remained relatively high thanks to sterling weakness, which has in turn helped exports and manufacturing. Chris Iggo, fixed income CIO at AXA Investment Managers, is among the minority who "believe the major risk is earlier monetary tightening than is currently priced-in"; some worry that major policy error could lead to sharp hikes in H2 2010. Nonetheless, money growth remains slow and Bank of England governor Mervyn King appears sensitive to this. "We see rates on hold through next year in the UK," says L&G's Drayson. "Quantitative easing has probably come to an end, but I don't think they'll be selling gilts back into the market next year - or ever, in fact."
Drayson does not expect an ECB move next year, either, despite "some hawkish talk". Weak bank loan data and the prospect of a "bumpy" and "uneven" recovery (Jean-Claude Trichet's words) would support continuation of unconventional measures. "Uneven" is certainly the word: while Italy and Spain continued to shrink into Q2 this year, France and Germany enjoyed a relatively strong bounce. Germany's businesses and consumers both say they feel better. France has seen seven months of increasing industrial production and an improving balance of trade - despite the strong euro. Still, Europe's unemployment remains high and, thanks to some job hoarding, will probably remain so, putting a cap on near-term inflation.
Combine this majority view on low inflation and low rates into 2010 with a rally in risk assets that may be running out of steam and there is a good chance that bond yields could remain depressed for some time to come. Even as quantitative easing gets put to bed and government bond issuance continues, G20 proposals on commercial banks' capital adequacy will introduce another big buyer. "That could be close to a complete offset of Back of England withdrawal," says Urwin at BlackRock. L&G's Drayson is not so sure that it will be enough to stop yields moving higher, "but hopefully it will make the transition smoother". A smoothing effect on US yields could come from creditors keeping criticisms of the government's enormous debts muted to avoid crushing their own portfolios. But "smooth" is a relative term: there is absolutely no doubt that we will see a "transition" - yields must eventually go up, curves must eventually flatten - and although that may be "smooth" relative to a full-blown bond market crash, there are plenty of reasons to expect rising volatility.
"People are drawing a straight line that says, if the dollar goes down, risk assets go up, and vice versa," says Dwane. "It looks like a lot of this dollar, sterling and euro money has gone into emerging markets and commodities, but to my mind it needn't all come back again." Selling risk into Treasuries arguably makes little sense anymore, but there is a good chance a lot of investors will do exactly that, reflexively, before realising the downside risk they have taken on. As Drayson says, "A correction in equities might cause a temporary drop in yields, but people will soon realise that buying government bonds is not de-risking: the government has taken on all of the debt of the private sector - you'd just be following that risk."
That is a recipe for choppy markets. "We are seeing, and expect to see, higher volatility across the US Treasury and swap markets," says David MacEwan, fixed income CIO with American Century Investments. "Getting that volatility right is key for asset-liability management."
Indeed - but deciding what to do about asset-liability matching in these circumstances is tough. Government bonds may look terrible purely as an asset, but if those yields are your liability discount rate they are by definition the risk-less asset. "Increased volatility of interest or swap rates should make pension funds even more careful about moving assets away from liabilities," says Laurens Swinkels, a senior researcher in quantitative strategies at Robeco who used to crunch numbers for ABP Investments. "If the recovery turns out to be weaker than expected and interest rates go down again, some Dutch funds could end up back below the 105% coverage ratio."
But matching duration involves hanging on to overpriced bonds (even a swap does not solve the problem, as big haircuts on credit assets mean that bonds are being favoured as collateral). "It's time to make sure you understand what your risk-free position is relative to liabilities - but not necessarily time to go to it," says Peter Routledge, head of pensions & employee benefits at Towers Perrin. "Lock yourself into a negative funding level and your sponsor may be unable to contribute enough to get you out of it."
Mark Hodgson, managing director with implemented consulting adviser Gatemore Capital Management, agrees, and laments that he sees many investors "blindly" heading to government bonds to "de-risk". "That takes no account of the long-term value," he says. "If we expect the 15-year gilt yield to rise by 0.5-1.0%, that could have a 20% impact on your funding level, even if your assets do very little. If you have a relatively strong sponsor and you can afford not to take all the risk out of your portfolio, let's take some profit from LDI and set it to work somewhere else."
The potential to win on both sides of the balance sheet - if you and your sponsor can stomach the tracking error - is tempting, even a no-brainer on a three-year view. "You should never buy something that you know is not a good investment," as Patrick Armstrong, co-founder of Armstrong Investment Managers, puts it, "and there is good potential to grow in excess of your liabilities in this environment".
But it is the second clause in that statement that might give investors pause. If we choose to let rising yields take care of our liabilities, where will we find growth with the capital that this decision frees up, after one of the biggest risk-asset rallies in history?
We could stay with government bonds, switching from directional to relative value exposures - MacEwan suggests the obvious curve-flattener, but also staggered central-bank exit strategy trades like short-UST/long-Bunds. This is also a currency-trading opportunity, of course, as Castlestone Management FX fund manager Brad Yim observes: "One of the key FX trade themes of 2010 will be the US's relative economic strength versus that of the EU and the UK. There is too much expectation for rate hikes in some currencies, and these will present interesting trading opportunities."
Investment grade credit, while not the screaming bargain that it was in February, has simply re-emerged in its traditional role of providing a modest spread over government bonds: at 230bps, it is still about 70bps over long-term levels. "Credit spreads are still wider than they were after Enron and Worldcom," notes Urwin. "It would be wrong to say it's expensive, but you now have to have realistic expectations."
High yield has seen an even more dramatic run-up, but selective names still yield 12-15% and higher-quality securities can deliver 8-10%, with default and refinancing risks declining. For those able to take more liquidity risk, high quality European ABS or non-agency MBS also offer value.
Inflation-linked bonds would appear attractive at the longer end of the curve where there is still some yield, but, as discussed in last month's article on stagflation, uncertainty around near-term inflation and uncertainty around the direction of real yields make this far from a one-way bet. Commercial real estate, which still offers yields that would repay investors handsomely in the event that inflation fails to materialise, looks better.
What about equities? Corporate balance sheets are being repaired, often via equity issuance. "That has had the effect of diluting equity and making the credit much safer," says Michael Hintze, CEO at credit specialist CQS. "Ultimately we are set up to see credit spreads continuing to grind in while equity markets do nothing."
On the other hand, while credit spreads have normalised, equity markets are still in the red and arguably better placed than fixed income securities for the medium term: "At some point investors have to look through equity volatility and recognise the risk that policymakers will err on the side of more growth and inflation, which is a pro-equity environment," says RCM's Dwane. "We think equity is much better value than lower-quality credits, and are puzzled as to why money hasn't moved into equities even more aggressively. Having said that, the S&P500 has gone from 12-times earnings to 18-times, and I can't, in my heart-of-hearts, say it's cheap anymore."
What does that say about emerging markets, which have outperformed world equities by 30 percentage points during 2009? These economies are the most likely to provide fundamental support to this kind of rally, and although their growth cannot replace lost US demand any time soon, it provides a theme that can begin to be priced-in by markets. The dollar-funded carry trade has done a lot of that already, generating some immediate downside risk if there is any sign of rising US rates or a dollar rally (which is true of commodities, too); nevertheless the dominant play in developed markets - rotate out of cyclicals into defensives - contrasts starkly with Ashmore Investment Management's advice that emerging market investors should now implement "tactical rotations from lower to higher beta, from sovereign to corporate exposure, from hard currency to local currency exposure, and from fixed income to equities". Many global investors are barbelling with both themes: "Alongside defensives, the two themes that I continue to play long term are emerging markets - which you can do with European stocks like Unilever and Nestlé, of course - and some sort of commodity exposure," says RCM's Dwane. The caveat is that others - like Pioneer Investments, for example - do see this year's rally as indiscriminate and now look to "take some profits and switch money into developed markets".
Emerging markets (outside Europe) can also be a currency strategy, as developed economies' balance sheets weigh on the dollar, euro, sterling and others. Global bond managers are almost universally bullish on local-currency emerging market debt. Investors may also want to exploit the rise in short-term volatility with a basket of FX alpha or global macro managers. "For those specialising in currency trading, 2010 is shaping up to be a particularly interesting year," says Castlestone's Yim. "Country-specific fundamentals set the tone in an environment where gyrations in investor appetite will periodically affect violent moves. Persistent high volatility would make holding long-term trades more difficult, and drive up the price of options that are often used as hedges. On the other hand, large moves can also provide attractive short-term trading opportunities for the more agile. The smart way to trade in such environment is to maintain a lower risk exposure and employ tactical trading to take advantage of extreme short-term price swings."
Indeed, across all asset classes, from equities to credit to bonds to FX, one risk likely to pay off for investors next year is active management, as we move from beta domination to markets in which sector rotation, bottom-up stockpicking and dynamic positioning will be rewarded. By extension, diversification is also beginning to pay off more clearly - and this is the key point for investors preparing for the next three-to-five years. The right kind of diversification is no longer a ‘balance' between high-risk, low-risk and risk-free assets: risk is higher across the board and traditionally ‘low-risk' positions could be false friends. If you and your sponsor can take the tracking error against liabilities for the next few years, it is time to embrace risk assets, managing that risk by diversifying economic sensitivities, trading time horizons and strategies. Locking in liability hedges is for tomorrow, when bond yields have normalised.
As Urwin puts it: "Have a very clear idea of where you are now, have a clear idea of where you want to be five years down the road, understand what risks you may need to take to get there - and then take them."