This blog post is available as a PDF here.
- Friday’s single day returns were pretty volatile – with historically large losses in GBPUSD – but generally markets only fell to where they were just a few weeks ago.
- The economic implications of the Brexit are fairly unknown. Given that the market does not like unknown things, we expect heightened short-term volatility.
- We believe this scenario highlights the importance of global macro-economic events on U.S. investors – a factor that was far less relevant several decades ago.
- With expectations of continued global volatility and surpassed rates in the U.S., we believe there are several steps worth considering for U.S. investors to help more actively manage risk.
On Friday, we received a number of inbound queries about our thoughts on the implications of the Brexit vote and our thoughts on market action in general. We wanted to bring you this special weekend commentary to provide our view on Friday’s market action, some insights into how we were positioned, as well as implications for our outlook on portfolio construction going forward.
That felt pretty bad. Was it bad?
Yes and no. The pound had its worst 1-day sell-off versus the dollar ever. At one point, overnight, S&P 500 futures were down nearly 7%. That said, S&P 500 futures also mounted one of their strongest rallies ever to close the day down -4%.
That is only a 1-day view, though. Consider that the FTSE 100 index ended the week almost completely flat and the S&P 500 is where is was in mid-May 2016. So if you weren’t panicking then, there probably isn’t a need to panic now.
So what’s up with all the violent market action?
We see two reasons.
(1) Miscalculated odds.
Markets do their best to discount the future into present prices. This means capturing both the magnitude and probability of future events with a single price. Often these are continuous events – but big, binary events like the Brexit can have tremendous impact.
So let’s use a simple analogy. In a month, I am going to flip a coin. If the coin lands on heads, you win $1. If the coin lands on tails, nothing happens.
Let’s assume there is a “market” where you can buy a ticket to participate in this game. How much would you pay for a ticket? Assuming the coin is fair, and the probability of landing on heads is equal to the probability of landing on tails, the fair value is $0.5 ($1 x 50% + $0 x 50%).
Now let’s say some news leaks and we find out that the coin isn’t fair. In fact, it is more likely to land on heads – with a 60% chance. How much will we pay now? Well, we’d pay $0.6.
And as we get closer and closer to the date, news keeps leaking that the coin is actually extremely unfair. Now it’s 88% likely to land on heads. How much will we pay now? $0.88.
Now it is worth pointing out that the second the coin is flipped, our ticket is worth either $1 or $0. There is no in-between. The shroud of uncertainty is lifted and the true value of our ticket is revealed based on the outcome.
So the day of the flip comes. The coin lands on tails. It turns out our information about the coin was either wrong (i.e. it wasn’t unfair) or an extremely unlikely event occurs. The value of our ticket plummets from $0.88 to $0.
That is, more or less, what happened with Brexit.
In a stay condition, the FTSE 100 would be worth one thing; in a leave condition, it was worth another.
So if we believed the odds were 1:1 of stay versus leave, the market would sit right in the middle until the vote finished.
The market didn’t believe the odds were 1:1, though. In fact, over time the market got more confident of a stay vote. By June 23rd, Betfair had the vote odds at 1.13:8:00 of stay versus leave, implying an 88% chance of a stay vote. Which is probably why from from June 14 to June 23rd, the FTSE rose 7%.
The problem is that the vote ended up being leave. Hence a quick and violent correction back to fair value in a stay condition.
(2) Market Structure
In the weeks leading up to the Brexit vote, the implied volatility for options increased dramatically.
The increase in implied volatility (which is equivalent to an increase in option prices) indicates increased demand versus supply, likely from an abundance of (a) speculators or (b) hedgers trying to protect their books against a leave scenario. This would have left market makers as the counter-party to these trades, causing them to carry a significant number of puts written on their book into the Brexit.
Of course, market makers don’t like to expose themselves to market risk, so they would have tried to hedge. The simplest form of hedging is called delta hedging, where the market maker shorts the same index of the put they are carrying. That way, as the index goes down and the put goes up in value, their short position makes money.
The problem is that these puts have positive gamma, meaning that the delta goes up as the option gets more in-the-money. To translate from greek jargon, that means that as the index fell further, and the option was worth more (and the market maker was on the hook for more), the market maker has to short-sell an increasing amount to hedge their position.
So for every tick the index fell, the market maker has to short-sell more. This causes an increasing amount of pressure, likely causing the index to fall further, causing the market maker to have to short sell more. This is made worse if it occurs during hours when there is less liquidity – like overnight markets.
The good news is that this sort of action cuts both ways. Eventually the speculators and hedgers will begin to monetize their positions (note that they typically operate on a different time frame than market makers). As they do, market makers can unwind their shorts. As they unwind their shorts (by buying back the shares), prices will be driven up, causing the other speculators to rush to lock in their profits. Suddenly we have a reverse scenario as buying begets buying.
If this is indeed the case, don’t be surprised to see a day next week where markets have a strong positive pop.
The great irony to all of this is that the market action has absolutely nothing to do with fundamental economic value. This is a great lesson for traditionally trained investors. In the day and age of high frequency market making, intraday movements are more gibberish and noise than meaningful signal about what investors believe fundamental value is.
How was Newfound positioned going into the Brexit?
Newfound’s portfolios are completely systematically managed – so our discretionary views on the Brexit did not impact portfolio allocations in any way.
Based on prevailing market momentum, our sector portfolios (U.S. large-cap, global, and U.S. small-cap) were fully invested, with no defensive allocation.
In our U.S. large-cap and global sector portfolios, we were either significantly underweight, or completely out, of the financial sector due to prevailing negative momentum. Our equal-weight approach also gave us a structural overweight towards the utilities and consumer staples sectors, which helped buoy the portfolios. Our largest drag was an overweight towards the energy sector.
In our small-cap sector portfolio, momentum had us underweight energy while our equal-weight portfolio design had us overweight utilities and consumer staples and underweight financials. These tilts helped offset the significant decline in small-cap equities.
Our multi-factor equity portfolio was also fully invested. While factors like size and value underperformed the S&P 500 by -0.54% and -1.02% respectively, momentum and minimum volatility outperformed by 1.47% and 1.82% respectively. Dividend growth was largely a wash. The net effect was that the outperformance from the factors helped offset some losses from equity market beta.
Our multi-asset income portfolio was largely insulated from a volatility perspective due to the large allocation we have to yield-driven asset classes (e.g. bank loans, high yield debt, emerging market debt). While these asset classes are certainly riskier than U.S. sovereign debt, their largely yield-driven returns help insulate them against large equity shocks and helped insulate against nearly 40% of the losses in a traditional 50% MSCI ACWI / 50% Barclay’s Aggregate U.S. Bond portfolio benchmark.
We want to stress that that none of our portfolio positioning was designed to create relative performance going into the Brexit. We want to stress that many of our portfolios are designed around trying to capture long-term trends. Binary events, like the Brexit, do not play into our portfolio decisions beyond how their expected impacts are discounted into price and volatility trends that affect our position sizing models.
What are the economic implications of a Brexit?
We don’t know. Frankly, nobody probably knows. The United Kingdom will have to renegotiate a large number of trade agreements with the EU constituent states and figure out how it will handle labor migration with the EU. There is a tremendous amount of logistics that will have to be negotiated.
What we do know is that the market doesn’t like uncertainty. So until these are worked out – or at least the implications are more well understood – we’ll likely see heightened volatility.
What are the asset allocation implications?
The Macro Matters
One takeaway here is continued evidence that the United States is no longer an insulated economy where we can focus solely on fundamental analysis. With sweeping global trade agreements put in place in the 1990s, and the role of technology in enabling global communication, the U.S. economy and the world economy have become inextricably linked. As investment professionals, we have to keep an eye on the macro-economic shocks that will affect corporate earnings abroad as well as the risk appetite of foreign investors in U.S. assets.
As it affects us today, we believe that passive, cross-geography diversification opportunities are dwindling compared to 20 years ago. Buying indexed exposure to U.S., foreign developed, and emerging markets no longer gives you the same structural diversification it offered twenty years ago.
Lower for Longer
With the vote to leave, the market implied probability of a July, September, or November rate hike plummeted to less than 10%. Even the December and February 2017 implied probabilities of a hike are only just above 20%.
While we believe this reinforces the above point – that the macro matters – it also highlights our general outlook of lower for longer. While this discretionary view does not inform our investment process (again, we invest entirely systematically), it does inform our discussions with advisors and why we think certain approaches to investing are particularly timely for the next decade.
The problem, as we see it, is that in our global economy, we have a number of central banks trying to act independently. Independent action creates unnecessary friction. Coordination would likely be a better policy.
The problem is that coordination either leads to coordinated success or coordinated disaster. Independent action can lead to frustrating frictions, but the risk of disaster tends to be much, much lower.
Nassim Taleb makes this point in his book Anti-Fragile when he compares the careers of a taxi driver and a white-collar worker. A taxi driver often has much greater day-to-day volatility in earnings, where the while-collar worker earns a steady and fixed salary. In an economic collapse, however, it is likely that the taxi driver will still have a job while the white-collar worker will earn nothing. As we like to say,risk is never destroyed, just transformed. A white-collar worker trades present earnings volatility risk for future “jump risk” (risk of a sudden and immediate loss). A taxi driver makes the opposite trade, willing to bear more day-to-day volatility risk.
We believe that is exactly the situation we are in today. Independent central bank actions can create frictions that slow the ability for the global economy to heal, but these very frictions help prevent complete global collapse. It is diversification in action. The portfolio analogy is that investors could just hold the S&P 500. In a growth scenario they will profit handsomely. The problem is that in a recession scenario, they lose a significant amount of wealth. So they diversify their portfolio with bonds. The result is slower portfolio growth rates, but with less risk of disaster. Coordinated central bank policy would be like just holding the S&P 500 in your portfolio: good times will be great; bad times will be a nightmare.
So friction it is!
But why can’t the U.S. just hike? Part of the problem is the ease of global flow of capital. If the U.S. begins to offer a significantly higher yield than other developed countries, and our debt is viewed as safer than other countries, it will likely invite huge inflows, keeping prices high and rates depressed. It will also likely drive up the value of the dollar, hurting profits for U.S. multi-nationals and putting downward pressure on earnings (ironically, hurting our economy). So with continued global volatility, a hike in U.S. rates may not have the intended effect as foreign investors scramble to take advantage of our higher rates.
Decreasing opportunities to passively diversify, increasing global volatility, and a for lower-for-longer policy … what can we do?
1. Diversify how we manage risk
In our piece The State of Risk Management, we demonstrated that approaches like Managed Futures and Trend Following have historically helped mitigate portfolio drawdowns with the least amount of performance drag. These approaches have even historically been able to generate crisis alpha, benefiting from global volatility.
2. Structurally reduce risk
We also found that approaches like low volatility equities can be useful to reduce risk. We also believe that asset classes that structurally tilt their total return source towards yield instead of capital appreciation (e.g. bank loans, high yield bonds, emerging market debt) can be used by investors to structurally reduce their equity volatility without necessarily sacrificing total return expectations over the coming decade.