Monthly Commentary October 2018
First the calm. The banshee calls from the Eurosceptic Conservative party members have died down (for now?). Britain’s negotiations with the EU continue unfazed by any sort of imminent deadline, although talks of an extension abound. Peter Hammond delivered his third Budget signaling an “end of Austerity”…. delivering cuts in personal taxation, more funds for the NHS and some ‘little extras’ for education (interestingly less than was earmarked for potholes); all provided with help from the magic money tree - which may quickly fade if Brexit turns out to be not so favorable. Given the context of the last 18 months, with UK politics around Brexit having significant impacts on sterling and UK markets, perhaps the lack of any major drama in October could be described as slow, but steady progress….? Doubtless of the Kempen view, all good newspapers will give you a far more explosive verdict filled with their own little extras; but let’s move on to consider where from an investor’s perspective things have been scary.
Within the equity markets, there is one word to use to end October, terror. Evidenced by the volatility shown by the so-called “fear index” (VIX). Most global equity indices were down over the month, somewhere between 6% and 13%. Whilst Apple is (just about) clinging onto to its $1trn valuation, it has suffered along with other tech stocks. Exactly what has caused the volatility appears unclear: critics could point to disappointing growth in EU data (but the US continues in its growth frenzy); fears of a worse trade war between the US and China; and fears over a tapering of Quantitative Easing (QE) globally and increasing of rates by central banks. To provide some context, the VIX has risen from 12 at the start of October (which it had broadly hovered around since May) to over 26 at the end of the month – this indicates significant expectation of significant market movements. Whilst it is true that it has been over this mark before, 2011 was the last time volatility remained stubbornly above this level. To try to understand where we are in the cycle and what might happen next what we now turn to consider….
Tapering…. which is defined as the process of reducing the growth in the money supply via a reduction in the rate of purchase of assets by government banks. Critics may point to the taper tantrum of late 2013 to try to understand if the current market sell-off is a reflection of quantitative tightening. As background, in 2013 the US Fed surprised markets by declaring it would slow its quantitative easing program (from $85bn to $75bn pa); markets spooked and the Fed delayed plans. From a simplistic perspective today, the Bank of England, the European Central Bank and the US Fed all now hold positions to slow easing and / or tighten monetary policy. Is it different this time? Probably yes. The tantrum of 2013 was caused in part by market surprise, in part by simultaneous weak economic data and by an expectation that without ongoing central bank support markets would revert to their levels supported by their pre-crisis fundamentals (i.e. higher rates and much lower equity values). On this first point, central bankers have been very clear, offering strong guidance that QE will not last forever and that they expect to unwind such positions as soon as practical (but without spooking the markets). On the final point, markets appear to have generally accepted lower earnings going forwards as an acceptance that longer-term rates will remain lower than pre-crisis levels.
Despite the above, the real key to it might be different this time lies in economic data. Economic data has been strong, particularly in the US (in Europe it has been more mixed, but hardly terrible). Interestingly, earnings data for corporates has also been relatively strong, but perhaps not as strong as investors hoped for, which may in-part have contributed to short-term volatility. As a thought experiment, looking further into the future, there is the potential that investment growth may be held in a gully of lower returns: if economic data is strong and companies perform well then central banks will increase the rate at which they tighten, reducing investor returns; if economic data is weak companies will perform less well but will be supported by central bank policy. In such an environment it seems unlikely that there will be significant rewards on the upside, but the potential for a major event, political or financial to cause a large downside risk.
For now, it is too early to declare if October is the start of something truly ghoulish, but we believe this may be the start of some real and ongoing volatility (compared to say the flash crash of May 2010). For a UK pension scheme now should be the time to sit up, take note and consider how robust their portfolio would be to a large move in equity markets. For those interested in how things may play out longer-term our 2019 Outlook should be consulted (https://www.kempen.com/en/news-and-knowledge/kempen-insight/outlook-2019)
“Markets can be compared to a complex, self-regulating system. If any individual factor moves too far away from a sustainable level action will be taken to restore equilibrium. Over October we saw an example of this as yields fell in response to falling equity markets, which themselves had fallen due to expectations of higher yields internationally.”Robert Scammell, Senior Portfolio Manager
Like a classic football match, yield moves in October were very much a game of two halves. Having risen by 0.17% in the first half of the month, 30-year nominal yields subsequently fell by over 0.2% in the second half. This volatility reflected large moves in global equity markets with the FTSE 100 suffering its second 10% correction of the year.
Interestingly, the cause of the sharp move lower in yields has one if its root causes in the previous move upwards. Both long and short dated yields had moved up to their highest level in almost 2 years, following expectations that global policy rates, particularly those in the US, were going to continue to gradually increase over the medium term.
It was this increase in yields, particularly in the US where 10-year yields have moved up by 0.4% since August this year and 1.8% since August 2016, that lead to the equity market correction. The subsequent flight to quality is what then led to yields falling.
The degree to which yields and equities influence each other (technically known as correlation) is a vitally important relationship as it is at the heart of investment strategy but it can be hard to pin down. The textbook definition suggests that as the economy expands yields will rise and so will equities, whilst during a contraction equities will fall and so will yields. Given bond prices go up as yields fall this means that the return on equities and bonds should be negatively correlated. As the return on equities falls the return on bonds goes up (this relationship is complex in theory as yields rise the net present value of the dividends decreases however this can be more than offset by declining risk premia and increased earnings). However things are not so simple in real life with the strength and even direction of the relationship subject to change (see chart 1.)
Most recently the relationship has been the opposite of what textbooks predict with return on bonds positively correlated with the return on equities (this means yields have been falling as equities have been rising.) This has been mixed news for pension schemes as whilst asset performance has been good liabilities have also been rising.
Pension schemes would prefer a return to the textbook example of correlation where yields rise and equities increase however in order for this to happen markets needs to move away from a reliance on low interest rates and central bank liquidity. This requires a normalization of policy, which has started in the US but remains some way off in the UK and EU.
No matter what the economic or market environment there is one situation where the correlation between equities and yields is almost certain. In an equity market correction or crisis equities returns and bond returns will almost certainly be negatively correlated. As equities fall investors seek a safe haven for their cash, buying bonds, pushing yields down and therefore increasing prices.
The scheme has therefore become undiversified at the moment of maximum need. Given diversification is often considered to be the only free lunch in finance this is sub optimal. In order to avoid this, schemes need to hold sufficient quantities of risk free assets that will move the needle in times of crisis. This typically means having a sizeable liability hedge in place. Schemes that do not have a significant hedge in place will continue to be exposed to a double hit during equity market corrections and unable to take full advantage of the benefits of diversification.