"Since January 26, we have seen a steep decline in equity markets—the kind of development that pulls news from the financial pages to the front pages. Is the recent market volatility isolated, or a sign of an impending avalanche?
While the volatility may feel extreme, it is not. The equity markets have seen at least 12 months of steady gains with low volatility and no shocks, so the recent market disruption is a bit like going to the gym for the first time after 12 months of sitting on the sofa: it's a healthy thing to do, but it hurts more than usual.
Fundamental Value Hasn't Changed
In our view, fundamental value hasn't changed. Before the downturn, eurozone and U.K. equities were attractive, as were some emerging market equities, while U.S. and Japanese equities were not. That is still the case. Before the downturn, many emerging market currencies were cheap and the U.S dollar was expensive, and that is still the case as well.
Additionally, the macroeconomic background and the geopolitical risk environment remain relatively benign. The macro influences that were significant in 2015 and early 2016, which had moved to the back burner, have remained there during these past few weeks.
So, neither the Where nor the Why of our investment process is really any different.
No Catalyst to Market Sell-Off
However, as we have been saying for some time, while strong and correlated market performance was broadly consistent with the fundamental backdrop, we didn't buy into the idea that risk was as low as it was being priced.
Additionally, we didn't believe that everything that was appreciating should have been, and we were not going to chase allegedly “low-risk” returns as long as we didn't see any catalyst that might change the situation. That proved prudent because, while the situation has changed dramatically, there wasn't really any catalyst.
Indeed, the best catalyst for the market sell-off the news networks can come up with is rising interest rates and inflation. But we're living in an era in which central banks are giving more guidance about the future of monetary policy than they ever have before. Central banks tell investors what they are going to do years before they do it. And nothing in their communication changed in the weeks preceding the downturn. So that does not seem to be a compelling catalyst to us.
Low-Vol Environment Has Created Vulnerabilities
The bottom line is the market environment of the past 12 months—consistent market gains with low volatility and no shocks—has created vulnerabilities. It's just like when a lot of snow on a mountain creates an avalanche; it builds slowly, and then collapses. No one can reliably say when those vulnerabilities might appear or when the avalanche might happen. Maybe it's all happening now, or maybe this is just the beginning and there's more to come.
So far, only a relatively small part of the market has been significantly affected—the part that loves to sell tail risk in good times, such as market operators who take on short exposure to volatility in exchange-traded funds and rules-based traders. These are systematic and algorithmic-based investing strategies. As far as we can tell, it doesn't appear that many investors have completely fled the markets.
As we entered the downturn, we were already downside-sensitive given the environment of the past 12 months. Downside capture is important to most of our clients—even more so than beta is—and increasingly it is what we are hired to manage. Our clients want diversification and stable (or consistent) returns, and they don't want to capture too much of the downside when equities fall steeply. So we've remained relatively defensive in our positioning.
We haven't been immune from the volatility, but our strategies are down significantly less than the indices have been, thanks to downside risk exposure being a key consideration for us for some time.
As expected, our long equity exposures in Europe and emerging markets have detracted from performance, but our short equity exposures in Japan and Canada, among other markets, have helped offset the decline. The story was similar in currencies: long and short positions in emerging markets detracted and added value, respectively; a short in the New Zealand dollar also helped.
And, despite re-risking our portfolios significantly since the August 2015 market correction, given the low-volatility environment of the last year, we are continuing to manage our portfolios in a relatively defensive way. As a result of this most recent volatility spike, we have further de-risked some of our exposures that are more sensitive to downside capture—long positions in eurozone equities and emerging currencies, in particular.
There is also a probability that a bigger hole in the markets exists, though we don't believe this is the first part of an extremely deep market plunge. But we can't be certain, and our defensive positioning should help to protect us if there is a severe event.
We also want to be in a position to take advantage of opportunities when the situation warrants—i.e., to have enough risk capacity to step in with larger buys if the market declines even further.
I recently discussed the market sell-off on CNBC's “Squawk Box Europe,” highlighting several of the same key points I mentioned above:
- It is important for a fundamental macro asset manager to seek to smooth out the highs and lows of market gyrations.
- It is easy to blame central banks, but central banks have provided guidance on their actions well in advance.
- Fundamental values for equities, bonds, and currencies haven't changed despite the recent market sell-off.
- The extended low-volatility environment has created risk-seeking behavior.
Past performance is no guarantee of future results. Diversification does not ensure against loss. There can be no assurance that any investment strategy will achieve its objectives, generate positive returns, or avoid losses.
Beta is a measure of the volatility of an investment relative to the overall market. Downside capture is a measure of an investment’s performance relative to an index during periods of negative index performance."
Thomas Clarke, Partner
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