Everything you have heard about yield curve inversion is true; nevertheless, everything that is true may not harm your investments. Yield curve inversion is a good predictor of recession, and there is a link between this inversion, recession prediction, and equity declines. However, being the first to react to flattening or inversion may not win you portfolio success.
Everyone talks about bear markets; however, it is surprising that this downturn definition is so arbitrary. Commentators are somewhat cavalier with their discussion of bear markets. It is a down move of 20% from a high price point. A correction is a down move of 10%. A bear definition could be applied to a individual asset, a sector, or an asset class.
There is a difference between risk factors and risk premia. This may be viewed as a subtle distinction, but it is important to think about the differences. Factors explain the return attributes of an asset. Those attributes may be either style or macroeconomic factors. Factors provide a description of what drives returns. A risk premium is what an investor receives for taking-on the risk associated with a factor. A risk premium is compensation for non-diversified risk which can come in the form of a style or a macro factor. A factor is a measurement of a characteristic. A premium is compensation for holding a characteristic. Investors want to be paid a premium for a persistent repeatable factor.
Let’s just make things clear. There have not been many yield curve inversions, so analysts who want to study the behavior of asset prices during inversions have limited data. Yield curves may signal recessions which may also signal a decline in equities associated with slower growth, but the timing links are highly variable. The risk differs depending on how the question is asked.
Are you a technocrats or a politician? If you listen to central banks, they will say they are just technocrats or experts who do not engage in politics. To discuss political implications of policy or have politicians involved in the discussion is an infringement on a central banker’s cherished independence. Only through independence and limited oversight can central banks do their sacred technical work.
This was a negative month for managed futures funds as measured by peer indices for a simple reason, range bound behavior in equities and a reversal in bonds. Equity indices have started to trend higher, but longer-term trend followers were not able to effectively exploit these moves in the second half of the month. Global bonds have trended higher for most of the month but smaller position sizes based on higher volatility limited gains. Oil prices offered strong gains, but the size of positions may not have large enough to make an overall impact on fund returns. Commodity trades are generally a small portion of the total risk exposure for large funds.
The cost of being wrong with political uncertainty is significant and the impact will be felt across many markets. The yellow jacket “uprising” has already shifted French economic policy and will also affect the direction of government. We may not be extremists but the fundamental pact between the governed and government is broken which is not good for any investments.
Last month nothing worked with all asset classes generating negative returns. October saw a shift in market sentiment toward risk-off behavior. Investors started to take loses and adjust to more defensive portfolios. Momentum was clearly negative early in November, but monthly returns are sending different signals with both US and global equities higher. Nevertheless, it is too early to make any statement that risk-taking is back on. Equity markets have come off lows but are not showing any trends. Credit ETFs declined sharply relative to Treasuries and long duration bonds gained on new fears of economic slowdown. Commodities declined on a sharp fall in energy prices.
If you have an asset that has an illiquidity premium, an optimizer will love it as a choice. An illiquidity premium is a dangerous area for investing. First, are you getting paid enough for illiquid? Second, is there a good way to measure illiquidity? Third, do you really know your liquidity needs?
A big problem with macro fundamental investing is getting timely data on the economy and then translating that information to effective investment signals. Government issued data generally are out of date and old information for forward looking forecasts. Hence, there is greater value on macro data that is current and prospective.
The classic 60/40 stock bond asset mix has proven to be a good core asset allocation. When in doubt, employing the simple 60/40 (SPY/AGG) asset mix as a base case has been an allocation that has performed well versus other diversification strategies. This allocation bias may be coming to an end.
It not a matter of like or dislike the fundamentals of equities in the current environment. When sentiment changes and volatility increases, reassessment of current exposures is warranted. However, concern about the macro environment should be increasing. Maintaining lower market risk exposure by more than half of core allocation from 60% to 30% or half equity beta exposure is appropriate. (The darker red signifies a stronger trend.)
“Categorization is not a matter to be taken lightly. There is nothing more basic than categorization to our thought, perception, action, and speech. Every time we see something as a kind of thing… we are categorizing.”
– Linguist George Lakoff
From The Geometry of Wealth by Brian Portnoy
Most investment work is about forming categories. We divide securities into asset classes. We make subcategories within an asset classes. We make industry classifications. We divide risks into different types of premia. There are value classifications. There are categories and classifications based on macro factors like inflation. Investors like to group. All scientists like to make groups and form clusters of similar things to find commonality.