Asset Allocator: October 2015

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: October 2015

 

In this week’s shorter note I want to explore two very different ideas – the first is how a recession might develop next year (and what impact that might have on ETF portfolios)  and secondly whether the idea of investing in a low volatility or minimum variance, smart beta ETF still makes sense? The linking idea is one of caution of course – that markets may not enjoy a smooth, upwards rise in 2016 as some fairly obvious risks begin to develop.

Lets’ look first at that pathway to a downturn in 2016 – and what we can do about this possible development as investors. A recent note from analysts at research firm Cross Border Capital observed that there’s a fair chance that a 2016 recession may be on the first where growth is collapsing even though interest rates are rising.

The core argument behind Cross Border’s Capitals argument is a familiar one, built around a strong deflationary pulse. They argue that the collapse of the Berlin Wall and the rise of capitalist Red China has had a profound impact on global output. We’ve seen over the last few decades billions of new producers enter the global market place – but not billions of lavish consumers. The net result has been a massive capacity surplus, much of it debt financed. In this scenario the vast pools of global liquidity are determined less by what central banks do than underlying business conditions – which are currently deflationary.

The London based analysts argue that these trends are even more true after the global financial crisis of 2009, as we’ve seen a colossal increase in capacity and debt, especially in China where a vast credit bubble is now steadily deflating. Corporates in the West are cash rich but don’t want to invest in new capex, dumping money into wholesale markets, where that liquid cash is then leveraged and put into the global liquidity system. Much ends up in China – and especially the shadow banking system. According to cross Border these “shadow banks have been behind the eye-watering 12-fold growth in the Chinese asset economy since year 2000.”

In their view this enormous global credit machine is now in danger of slowing down, with the global wholesale markets the key driver of change. The most powerful motor may be corporate cash – and what happens to it in 2016. They believe that three threats could emerge:

  • The supply of collateral for these giant credit and bond markets may prove insufficient.
  • Larger ‘haircuts’ demanded by nervous wholesale lenders can cause the collateral multiplier to slump
  • The supply of new cash savings into the markets can dry up.” This is the current problem because our index of US corporate cash flow has already peaked and is heading lower”.

If these observations are correct, Cross Border Capital reckons that the following events might occur: 

  1. US corporations start to experience weaker cash flows and react by cutting back on industrial new orders. “A recession looks close.”
  2. US corporate credit spreads should start to widen out, consistent with deteriorating cash flows and weaker balance sheets. One key measure to watch is the spread between US corporate CCC (junk) and single-B (high yield) bonds and how much that has increased
  3. US wholesale markets start to experience a shortage of funds and call back loans from the offshore Eurodollar market. According to Cross Border Capital outflows from the US have coincided with QE1, QE2 and QE3. Funding crises in the US have seen money flow back from the Eurodollar markets to the US.
  4. The Eurodollar markets start to pullback funds from China and other Emerging Markets. “We note that comparing the size of Chinese net outflows to the size of her $US3.6 trillion stockpile of forex reserves gives bad not good news because China’s financial health depends on the flow of new dollars and not the historic stock. Looked at another way, commentators who cite ‘global imbalance’ arguments where Chinese savers fund America’s deficit have it entirely backwards, since US banks have financed the Chinese credit boom”
  5. Fringe banking areas in Emerging Markets begin to collapse. Another key market to watch here is the “plight of the Chinese shadow banking sector, where loan growth has skidded lower and actually contracted year over-year. These institutions supply around one-third of total loans.”
  6. Demand for ‘safe asset’ G4 Treasuries soars. “Weaker liquidity, by heightening financing risks, underscores the demand for ‘safe assets’ which bid down term premia and these account for nearly three-quarters of movements at the long-end of the yield curve.”

I have to say that although there’s nothing preordained about this pathway to a recession, it sounds horribly plausible. In this logic 2016 could be very ugly indeed, especially as Chinese net capital outflows of the current order of the current magnitude typically imply much lower levels of Global Liquidity. And Cross Border Capital observes that that their current index of global liquidity is at sub 30 levels which are “typically recessionary….With 2016 also being a US Election Year, the prospect of an upcoming US recession could prove very interesting? And, throw in the likelihood of a substantial devaluation of the Chinese RMB, given the breathless pace of net financial outflows, and the scope for turmoil ratchets higher! You can see why we are already betting on a QE4, or is it QE5?”

My own take on this is that Cross Border may be a little too nervous about global liquidity but it’s undeniable that we are in a very difficult market. Until we see evidence of three things I’d be keen to take risk off the table i.e be more defensive within a portfolio:

  • A more sustained pickup in the Eurozone
  • Sustained Chinese government action to arrest its slowing growth rates
  • Interest rates starting to rise in the US as an indicator that the Fed is not worried about market instability.

The portfolio implications are now clear. I’d probably consider moving away from risky bonds such as high yield and sitting tight in lower risk fixed income securities – probably long dated US Treasuries. I’d probably have a bias within the equity portion of your portfolio towards European assets although the contrarian amongst you might start to slowly move into emerging markets equities.

I’d also consider making sure that whatever equity exposure you have comprises more defensive stocks – possibly even stocks with low levels of volatility.

All of which brings us nicely to our second observation – that minimum variance or low vol indices seem to be working. That at least is the conclusion of a very recent report from S&P Dow Jones Indices Research called “The Persistence of Smart Beta”, October 2015 by Hamish Preston, Tim Edwards, and Craig Lazzara. If you want to see the report in full the link is here - Read more.

To recap – the strategy of low vol or minimum variance investing has been around for many decades within the academic economist community. The idea is simple. Build an index of stocks which deliberately excludes the more volatile stocks. As a ‘risk anomaly’ the phenomena was first discovered by Haugen and Heins in 1975, when they found that stocks with lower volatility in monthly returns experienced greater average returns than for the high volatility stocks. The net effect of this very persistent anomaly can be seen in the table below using S&P’s own low vol indices.

Graphic - S&P 500 Low Volatility Index Outperformance

 

Research report after research report has now found a fairly consistent “ 12% spread between low- and high-volatility decile portfolios, even after accounting for value and momentum effects. More recently, various authors have shown that such anomalous effects appear to be present in most equity markets, globally”.

The S&P authors decide to check the persistence of the low volatility factor using up to date numbers. In particular they investigate the strategy on a relative basis (i.e., in comparison to a market benchmark) and over a suitably long period to capture longer-term trends.

The risk-adjusted relative return shown in the chart below is calculated as follows: “at each point in time, the previous six-year daily volatility of returns for both the S&P 500 Low Volatility Index and the S&P 500 are calculated, and the six-year total return of the S&P 500 is multiplied by the ratio of the two volatilities to derive a “risk-adjusted benchmark return.”

S&P 500 Low Volatility Index Six-Year, Risk-Adjusted Relative Return

 What’s startling is that according to the authors apart from two periods around 2000 and 2008, “the pattern of risk-adjusted annual returns remains relatively flat; the oscillations persist around a stable, positive mean. If anything, notwithstanding those two major events, the level of the long-term, risk-adjusted relative returns would appear to be increasing over time. In particular, the current reading (covering the years since the market for U.S. equities began its remarkable bull run) is as good as, if not better than, what might be expected from history and current circumstances.” If the S&P analysts are right, the portfolio implication is clear – in key developed world equity markets such as the US and to a lesser degree Europe, make sure that your portfolio prominently features low vol or minimum variance index trackers and ETFs. You may miss out on some of the upside of strong positive momentum markets but overall you’ll be a net winner especially if markets do correct in 2016. 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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