Macroeconomic Occasional

In the last Macroeconomic Occasional of 21/02/2020, the S&P 500 closed at 3340, the ASX 7139, the AUDUSD ~0.6600 and Aust Govt 10year bond yields ~0.97%. These represent moves of - 25.5%, -29.0%, -9.25% and +1.75% respectively (2489, 5068,0.5990 and 0.0.78%) in just over six weeks to April 6th.

The speed and magnitude of the moves reaffirm the requirement for investors to hold core investment beliefs that are flexible and firmly held at the same time.

The suggested potential agenda items for an investment committee are the same save for a change of sign:

  • Rebalancing for the sharp a̶p̶p̶r̶e̶c̶i̶a̶t̶i̶o̶n̶ depreciation of risk assets
  • Confidence that defensive assets will appreciate and be liquid in a significant risk event
  • Review of diversification and correlation assumptions - particularly with respect to Bonds, Gold, CHF and JPY
  • Application of tail risk strategies
  • Opportunities presented by the historical low high of option prices

The Notes from Underground:


What happened, what did we learn (or at least were reminded of...) and what next?

Investment Beliefs - the primacy of risk, constant risk budget, multi-asset risk management

  • Do not attempt to time markets
  • Manage to a constant risk budget
  • Rebalance to maintain the portfolio at the risk budget (Now- buy risk assets/sell defensive assets)
  • Manage the risk and reward characteristics of the whole portfolio
  • GS reports the March quarter-end pension fund requirement to rebalance was US$150bio, the largest recorded. (For context GS estimate $25bio of outflows the week prior)  
  • The 60/40 portfolio (60% S&P500 40% UST10yr) lost 17% in March.

A precise definition of "Defensive Assets"

  • A "defensive asset" appreciates in times of stress and is quickly and easily liquidated
  • Beware misnomers like "credit". Be careful of "fixed income"
  • Obviously, real estate and infrastructure do not meet the definition
  • Cash is cash. It doesn't appreciate and a term deposit is not liquid. See also APRA
  • https://www.apra.gov.au/sites/default/files/letter_cash_investments_options_non-cash_holdings_industry_guidance_june_2018.pdf
  • If defensive assets aren't defensive one can't rebalance
  • Q. What is the defensive asset if sovereign bonds yield zero and start acting like currencies? Note to self - Treasury Inflation-Protected Securities (TIPS), maybe long-duration is ok?

Correlation is an assumption

  • Believe in diversification, but...
  • "Unknowable" Capital Market Assumptions are forward-looking assumptions, and
  • the correlation assumptions are very important.
  • Sovereign Bonds. see March 10th thru 23rd (12Mar20: the US 30-year Treasury yield snapped back to 1.37%, virtually double its intraday low of 70bp)
  • Gold: disappointing - perhaps the local price of Gold behaved or allocate now?
  • CHF: a long term favourite?
  • JPY: long-dated options as tail risk hedge? (when will volatility normalise?)

Market structure - listed vehicles

  • Listed investment companies/trusts are an inferior investment vehicle
  • Wrapping a listed structure around a strategy doesn't create liquidity
  • except for the fund manager
  • or, perhaps, if you can sell to another ASX participant (Grandma?)
  • The range of price to NTA for ASX entities over 5 years is -35%/+20% and
  • is very highly correlated with good and bad times. i.e when you need to sell (buy) so does everyone
  • Even if there are market makers "arbitraging" and the redemption/application processes insulates you from idiosyncratic fellow investors:
  • The Ishares 20 year iShares Core U.S. Aggregate Bond Fund, the world’s largest debt ETF (which owns some of the most liquid securities in the world) closed at a 4.4% discount to its net asset value, the largest divergence since 2008. (ref Grants and a dislocation that Bloomberg ETF analyst Eric Balchunas describes as “unusual.)
  • The VanEck Municipal Bond Fund ETF closed at a 17% implied NAV discount.
  • GOOD NEWS in oz - Look out for a new structure that permits unlisted and listed investment entities to be interchangeable and therefore fungible.


CoCo's (Hybrids for Australian retail)

  • "CoCo's"  or convertible contingent bonds is the label of complicated securities designed for banks to meet regulatory capital requirements. They are subordinated and become equity in times of stress.
  • In Australia, we call them "hybrids" and permit salespeople to sell them to retail customers.
  • Deutsche Bank A.G. announced it will not redeem the $1.25 billion of 6.25% AT1 contingent convertible perpetual bonds (CoCos) on their April 30 call date, sending the securities down 5 points to 82 cents on the dollar. Reuters notes that “banks almost always redeem [CoCo debt] when the first ‘call’ date comes due, or risk stoking speculation over their cash and solvency position.”
  • For example, NABPF traded from 107.00 on Feb 14th to 82.64 on 23rd March representing a -23% decline over a period that the ASX declined 35%.
  • Highly correlated with good and bad times. When you need to sell (buy) so does everyone
  • Hybrids are not defensive assets


Predicting the Low

  • An advantage of the constant risk budget belief is that rebalancing doesn't require a market timing decision (though you must have a clear definition of risk)
  • Howard Marks reminded us not to expect to pick the low
  • However, the three conditions cited by commentators for recovery are:
  • Good news on the medical front
  • Financial market stress confirmed as abated (see below)
  • Improving real numbers - watch the weekly jobless claims number
  • CS's early call was a "realistic worst-case"-2% annual GDP in the US, a 20% fall in earnings and the S&P500 at 2,200.
  • In the US, $550bio of investment-grade credit is expected to be downgraded to high Goldman published a good piece "A light at the end of the tunnel" which included some historical comparisons that point to an S&P500 low between 1950 and 2234 (with an outlier at 1963). Since this note, they have revised 2nd QTR GDP in the US from -24% to -34%
  • There is a consensus that the, particularly FED, central bank action (very large, very quick, targeted) has addressed credit market plumbing and mitigated left tail risk - i.e we saw the worst of investment-grade credit on March 23rd. Monitor cross-currency basis swaps and Italian sovereign spreads as credit stress indicators.
  • If one has "dry powder" or is yet to rebalance, it is likely sensible to have allocated ~70% already and to expect to be fully allocated over the next 2-3 months. At least till the next news on health...