You may have heard option traders talk about the ‘volatility smile’. Recent events might add a new term to the traders’ lexicon: the ‘risk-free yield curve smile’.
As I write in mid-October the US stumbles towards the cliff-edge of default. You’d think this would send tremors through the entire bond market, but while the one-month Treasury Bill yield tripled over the past few days, three-month paper has barely budged – resulting in that bizarre ‘smile’ from the yield curve.
You can blame inefficient markets or inefficient politics – like the Fed’s ‘tapering’ strategy, this reminds us that macro stuff can still throw curve balls at bottom-up investors.
And yet the trend away from ‘risk-on, risk-off’ remains intact. In February 2012 I noted that the CBOE S&P500 Implied Correlation index had started to decline: it has continued to do so and now sits at just 50. The French asset manager TOBAM regularly calculates the ‘diversification ratio’ for a number of market indices – the ratio of a portfolio’s securities’ weighted average volatility to its overall volatility. The higher the ratio, the more diversified the index constituents are. In May 2011, the MSCI World index sported a ratio of 2.25. By August 2013 that had powered up to 4.63. Select and re-weight to maximise this ratio from the index constituents, as TOBAM does, and that ratio has soared from 4.97 to 16.32.
We see signs of this growing pot of alpha in this month’s IPE. In our Strategy Review, one global equities manager running a similar regional exposure to the benchmark’s outperformed it by 12 percentage points in one year. The other two got their regional allocations all wrong, and yet both still outperformed the benchmark over 12 months. Moreover, as the summer sell-off in emerging markets intensified, one stayed top-decile while the other hit the buffers. Regional allocations predicted very little.
In our article on valuation the breakdown of blocks of regional risk keeps coming up. Thanks to the improving US economy, S&P500 stocks with the highest foreign earnings exposures are at their lowest valuations, relative to domestically-focused stocks, in over a decade. In Europe it’s the other way around. This cuts across both regions and sectors; the next step in the correlation-breakdown will deliver differentiation between the best- and worst-run companies exposed to the least favourable macro trends.
Why have these trends withstood the most recent top-down shocks? Rather than the shocks to growth, injections of liquidity and plummeting rates of the post-crisis years, 2013 has been a year of improving growth, talk of withdrawing liquidity, and rising rates. Before, everyone faced the same big problem (no growth) and benefited from the same drastic remedy (QE and zero rates). Now there is growth for those well-managed enough to get it, and the feckless and indebted are running out of free money. We have seen this at country level: the emerging markets sell-off was most acute for those running current-account deficits. We are beginning to see it at company level, too.