InvestmentsJan 30 2019

How to tackle market turmoil

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How to tackle market turmoil

While 2017 proved to be an almost perfect year for portfolios globally, with high risk-adjusted returns, 2018 proved to be a very difficult year, with traditional asset classes mostly down on the year and volatility up.

Faced with these conditions, we estimate that less than 5 per cent of the European portfolios analysed – including moderate, conservative and aggressive – recorded positive returns to the end of last year; the worst result since our database started in 2013.

Around five years ago, European investors could invest in products linked to global government bonds and achieve positive carry with low volatility and low correlation to global equity markets without taking any currency risk.

 

As can be seen in the table below, investors find themselves in a situation where the currency-hedging cost is far higher than the yield-to-worst (thus negative carry) with higher volatility and a similar level of correlation to equity markets.

Unless an investor has a very strong view on interest rates falling, or a positive view on the underlying currency to leave the position unhedged, it is clear that the current characteristics of a global government bond product hedged into sterling is unappealing.

 

Bloomberg Barclays Global Government Bond index characteristics

Date

Yield-to-worst

Hedging cost

Correlation to MSCI ACWI

Volatility

Jan 1 2014

1.7%

0.0%

0.3

4.8%

Oct 31 2018

1.5%

-2.7%

0.2

6.2%

Source: Natixis Investment Managers, Bloomberg. Correlation and volatility are calculated using prior three years data on a monthly basis in USD. Hedging cost is the annualised cost for a EUR investor to hedge the USD using 3m forward rates.

The best way we can summarise the current environment is that the ‘investable universe’ for European investors has shrunk and there is generally less choice available. This applies not only to the fixed income world, but clearly to other asset classes and instruments as well.

As a result, European investors have a dilemma in asset allocation.

They may favour European assets within portfolio construction in order to bypass the hedging cost but as a result sacrifice the diversification benefits given by non-European assets. Specifically in the UK we have seen less interest in fixed income as a whole, and global fixed income in particular, in 2018. 

To add to the difficulties in what is an already challenging environment, investors are faced with a market that has delivered good past performance but low yields going forwards. As an example, the yield on a typical 70/30 portfolio is just 2.6 per cent.

Key Points

  • European investors could invest in products linked to global government bonds and achieve positive carry with low volatility
  • We have been in an investing environment where investors had enormous choice
  • UK clients are going to have to position themselves ahead of the Brexit deadline in March in order to manage their potential downside

 

Our concern is investors may build portfolios using the rear-view mirror.

With the benefit of hindsight, we have been in an investing environment where investors had enormous choice. Since the financial crisis, almost any combination of credit, duration and equity risk would have yielded fantastic risk-adjusted results.

For example, the rolling two-year Sharpe ratio for 10 incremental combinations of Barclays Euro Aggregate and MSCI All Country World consists of three distinct periods: the pre-crisis period marked by high dispersion, the post-crisis period where Sharpe ratios were very uniform, and the recent period where dispersion is once again increasing.

The post-crisis period was unusual in that a portfolio consisting of any combination of bonds and equities would have yielded a positive return over a two-year horizon – hence the always positive Sharpe ratio – and the difference in Sharpe ratio between combinations was low.

This resulted in low dispersion in outcomes due to the high returns in both bonds and equities, coupled with an environment generally tainted with low correlations between traditional assets and low volatility.

In addition, and to further complicate investment strategy, UK clients are going to have to position themselves ahead of the Brexit deadline in March 2019 in order to manage their potential downside. Recent global market volatility has been elevated and has remained so.

This has created a very uncertain investment landscape and an uncertain expected outcome across a number of regions and asset classes for 2019.

With this in mind, and given our observation that client models in the UK have a domestic bias and higher equity allocations than their European peers, this has led to a drift down in market capitalisation size.

Unfortunately, recent market volatility has exposed the risks associated in investing in small and mid-sized stocks, whereas in recent years these stocks displayed reasonable resilience to bouts of market volatility.

This is likely due to clients shifting exposure, in general, into equities benefiting from good returns and below average volatility (outside of these bouts largely associated with rapid recoveries). This shift has supported stock prices in stocks that tend to be sensitive to liquidity.

In recent months this support has waned and a number of small and mid-cap funds have struggled to perform.

Our view is that it would be unwise for investors to assume that the post-crisis period of uniform Sharpe ratios can continue indefinitely. 

Investors’ focus should perhaps be less centred on market expectations, which arguably has already gifted us, and centred more on what they can do to improve portfolios.

If investing in sterling-hedged fixed income funds, does the underlying risk-adjusted yield justify the investment? Is the equity portion of the portfolio radically overweight FAANGS (Facebook, Apple, Amazon, Netflix and Google)  or other similar tech stocks?

What can be done to improve diversification?

James Beaumont is head of advisory and consulting, dynamic solutions at Natixis Investment Managers