My apologies for the lack of posts over the past two weeks. I have been out visiting clients in Canada and Europe – not an excuse, so lots to post this week!
A few posts ago, we talked about the “Correlation Blues” and its’ implications for the hedge fund industry and in particular, macro-based strategies. We will add to that thought in a minute.
On the correlation front, remember the “Deficient Frontier” post, courtesy of Don Coxe? Well, there is more bad news for traditional asset allocators.
Source: Datastream, Goldman Sachs Global ECS Research
This chart courtesy of Goldman Sachs (yes, they do some excellent work - thanks Matt Miller at Glaxis Capital for bringing this to my attention), shows that bond yields are now highly correlated to equity prices in Europe. Importantly, once rates fall below 4% nominal levels (i.e. assume 2.5% rate of inflation and 1.5% real return), correlation quickly rises with stocks. This makes sense, given that rates at 2% for the U.S. 10-year bond imply both negative real returns (deflationary) and a contracting economy. So if yields rise, the economy is doing better and therefore expected earnings will do better, and thus stock prices rise. This is clearly bad news for the "free lunch" associated with prudent diversification and asset allocation. When this eventually hits North American portfolios, watch out. Why? Because there will be nowhere to hide - except maybe cash in the traditional investing world.
But what might trigger this in our markets? My guess is the upcoming election debates in the U.S. – will post later on that – but my bet is the rhetoric and brinksmanship will reach feverish levels, again forcing yet another leg down in consumer confidence. Lack of action will eventually bring on the bond vigilantes who will demand greater return for the elevated risks they are taking. Can this be avoided? Of course, but it will get very bumpy. Expect the volatility of rates to exceed that of equities comfortably into the future.
In the “Correlation Blues” post, we discussed Global Macro strategies and other trading strategies to proactively take advantage of high correlation and volatility. J.P. Morgan has recently come out with a paper recommending Global Macro strategies for another good reason: performance in a recession. Lombard Street Research’s Charles Dumas has pegged a 2012 recession in developed markets at better than 50/50 odds. Macro strategies can add a lot of value in this scenario. The chart below shows Sharpe ratios for various hedge fund strategies with and without a recessing environment.
Source: J.P. Morgan Hedge Funds During Recessions, Bloomberg
Note that macro strategies yield positive Sharpes in both environments. I agree with JPM’s assessment that even if a recession is averted, the “downside risk of this “hedge”, however, looks very limited as the alpha of macro hedge funds during economic expansions is still positive and its’ average correlation is comparable to those other hedge fund strategies”.*
Now to add some fuel to this fire, Deutsche Bank ("DB") in their terrific strategy report entitled “Long Term Asset Return Study – A Roadways for the Grey Age” suggests we will see no fewer than 3 recessions before 2020!
DB’s rationale is very sound. The ‘Golden Age’ period (1982-2007) was one where the volatility of the business cycle was dampened by falling inflation and stimulative monetary and government policy whenever a “shock” was experienced. We are now up against the wall, as the public and private sectors increased leverage tremendously. As many have argued, unwinding this situation will at a minimum sharply reduce global growth and according to DB, shorten the business cycle. They expect recessions in 2012, 2016 and 2020. This will have “major ramifications for all asset classes and policy makers, and will ensure that the ‘Grey Age’ is not for the buy and hold investor. Trading around these regular business cycles will be key, in our view.” **
Included in the Global Macro space are the CTAs – folks like AHL Man, Winton and others. These funds, again because they are long volatility and trade trends up and down, also make sense in this decade.
* J.P. Morgan, Global Asset Allocation, September 23 “Hedge Funds During Recessions” page 3
** September 12th, Deutsche Bank Special Report, “ Long Term Asset Return Study - A Roadmap for the Grey Age” page 11