Perspectives

Uneasy euphoria

2017 was a good year for markets, almost too good in fact.  For the first time in history, the S&P 500 Index had no negative months during the calendar year. 2018 has started off with similar gusto, mostly off the back of year-end tax cuts, but there is a certain self-evident uneasiness about the euphoria this year. After all, how can a market go so high for so long without a meaningful pullback? Credit spreads are testing new lows, valuations across asset classes are stretched, complacency about risk is rampant, and, of course, volatility is at historic lows. The market is impossible to predict in part because fundamentals only matter in the long run.  In the short run, momentum, trends, and sentiment dominate. In the meantime, we are focused on the ground beneath our feet, analyzing market moves and economic data to identify the hidden fault lines running through portfolios.

As you probably know, we continuously verify that we are taking the risks we want, in the amount we want.  Each day, we scrutinize our portfolios and take measure of small, seemingly insignificant tremors that can reveal new, unstable fractures forming in the market. These information days, as we affectionately call them, help us map the contours of future seismic activity in the market. Knowing the place and potential magnitude of disruptions can be more valuable in portfolio construction and risk management than nailing down the timing part.

While the current low volatility environment can mask certain risks in the market, our approach to stress testing does allow us to “see through” noise at the asset-class level to better measure underlying factors of risk driving the market. Right now, the market is dominated by three primary risks: beta (sensitivity to equities), credit risk and interest rate risk. 

Even though interest rate risk is the most prevalent risk that we see across asset classes and the most likely to ensue, the consequences of this risk are relatively small when compared to the other two. The Fed has told us it will continue to raise rates and, on the back of stronger economic data, a globally synchronized recovery and recent tax cuts, it will likely hike rate faster going forward. However, even though this risk may be the most imminent, its effect on bonds will be mitigated by a number of factors. The Fed has done a reasonably good job of guiding markets on the trajectory of rates, allowing markets to gradually price this risk in over time. Furthermore, absent default (the credit risk element), bonds simply cannot fall as far due to interest rate movements alone.  At the most extreme, a 30 year bond would lose roughly 15% of its value from a 1% rise in interest rates.  While not comparable to the nearly unlimited losses that an all-equity portfolio can experience, such losses would be alarming to investors who expect greater capital preservation from their bond portfolios.  We mitigate this risk in portfolios by using Low Correlation defensive strategies, each of which has very little outright exposure to interest rates, but can generate income while preserving capital.

By virtue of how tight credit spreads are at the moment, credit is another concern in the markets, albeit not nearly as prevalent across asset classes as is interest rate risk.  Corporate default rates are historically low and, relative to US Treasuries, corporate bonds are yielding very little.  As this economic expansion gets long in the tooth and we begin to see recession risk creep up in a number of areas, there is a decent likelihood that credit risk will rear its head again.  Credit cycles tend to be more violent than interest rate cycles and credit-sensitive investments (particularly high yield bonds) can act more like equities than debt during periods of volatility.  The risk of the credit cycle ending suddenly is significantly lower than that of a sudden change in the interest rate cycle, but the effects would be far more damaging to a traditional portfolio because of bonds’ inherently higher sensitivity to default.  We mitigate this risk in portfolios by using shorter-term and higher-quality exposure to credit through our Low Correlation Defensive strategies.

Finally, beta is probably the hardest to get a handle on because current equity markets are so interconnected to interest rates.  The consequences of an equity market rout would also be the most impactful to a traditional portfolio because equities typically represent the lion’s share of a moderate portfolio allocation and their potential volatility is far greater than say credit investments or bonds. And, because investor sentiment can dominate equity behavior in the short run, this risk is the most unpredictable of the three. Equities are valued, in part, by discounting a company’s future cash flows by prevailing interest rates. This is the primary economic integration between equities and interest rates, at times a relationship that can lead to correlations of as high as .75. Should investor sentiment turn negative, or the Fed suddenly accelerate its interest rate trajectory, the damage to bonds would be evident, but the damage to equities at these valuation levels would be far worse.  We are most cautious in this area of portfolios, both in making sure that the equity strategies that we use have as little sensitivity to interest rates and in make sure that overall exposure to beta is limited. We do this through our Low Correlation Growth strategies, whose beta sensitivities range from just 40% of the overall market to roughly 65%.

Share this article: