Friday, 16 May 2014

Comfortably Numb: A Note on Volatility

Volatility has been low and falling across many markets for months. Volatility in US equities, measured by the CBOE Volatility Index (the VIX Index), has returned to the low levels seen ahead of the Great Financial Crisis (GFC). 

Volatility of US Treasury bonds, measured by the Merrill Lynch Option Volatility Estimate (the MOVE Index), is also back to 2007 levels. 

Currency and commodity volatility has also fallen to rock bottom levels. Past experience shows that while current low levels of volatility have persisted at times for over a year. Investors are lulled into a "comfortably numb" attitude in which they act as if low volatility equates to limited investment risk. Unfortunately, periods of persistent low volatility have often ended with sharp spikes upward in volatility. In three recent episodes, in 2007-08, in the spring of 2010 and the spring and summer of 2011, the periods of low volatility have ended with sharp corrections in equity and credit markets and rallies in high-quality government bond markets. In one recent episode, in the spring of 2013, low volatility ended with a sharp selloff in government bond markets and a more moderate and temporary dip in equity markets. 


Why is volatility so low?

It is a bit puzzling why volatility is so low. Many of the types of factors that have caused volatility in the past are present currently.

  • Geopolitical risks are not low, with tensions over Russia's annexation of Crimea, unrest in Ukraine, the territorial dispute between China and Japan, and elections in India and Turkey.
  • Growth risks are not low, with global growth 1% lower than forecast in 1Q14 and OECD leading indicators now showing fading growth prospects in most regions.
  • Although currently masked by rising food prices, deflation risks are not low and may prompt both the ECB and the PBoC to undertake further monetary easing soon.
  • Equity valuations are stretched. In his quarterly letter to investors, Jeremey Grantham of GMO estimated US equities to be 65% overvalued, while John Hussman of Hussman Funds using similar methodology judges US equities to be 75% to 125% overvalued.
  • Bond valuations are more difficult to judge, but most investors consider government bonds to be overvalued due near zero policy rates and large scale bond purchases by central banks. 
  • Credit spreads are tight, back to pre-GFC lows, for high yielding junk bonds and for European peripheral countries including Portugal, Ireland, Italy, Greece and Spain.
As Jan Loeys, Chief Global Strategist at JPMorgan recently noted, "low volatility is not low risk". Falling volatility is sometimes a good thing for financial markets, but a lengthy period of persistent low volatility can have a downside: it can create moral hazard as it eliminates caution and encourages excessive risk taking and use of leverage. 

Nicholas Colas, chief market strategist and Convergex Group, puts the blame squarely on central banks: "Central banks now stand perennially at the ready to address any systemic volatility quickly and with overwhelming force … As long as central banks feel they must respond to weak economic conditions with strong medicine, equity investors will feel that the Fed, European Central Bank, Bank of Japan, and other central banks will be in their corner.” 

This results in what Jeremey Grantham calls "the driving force behind the recent clutch of bubbles: the 'Greenspan Put', perhaps better described these days as the 'Greenspan-Bernanke-Yellen Put', because they have all three rowed the same boat so happily and enthusiastically for so many years".

Edward Chancellor of GMO goes on to explain, "Speculative bubbles tend to form when market participants believe that financial risk has been underwritten by the authorities. The 'Greenspan Put' appeared in the late 1990s after it became clear that the Fed was prepared to support falling markets but wasn’t going to act against the bubble in technology stocks. Fed policy hasn’t significantly changed since then. Monetary policy in the aftermath of the financial crisis has aimed to put a floor under asset prices, encouraging investors to take on more risk … Whenever a cloud appears over Wall Street, market participants have come to expect more quantitative easing and guarantees of perpetually low interest rates. The personnel may change at the Fed, but the 'Greenspan Put' remains in place."

How will low Volatility end this time?

The relevant question for investors is when and how will persistently low volatility end this time? Will it end as it did in 2007, 2010 and 2011, with a sharp selloff in the equity and credit markets and rally in government bonds. Or will it end as it did in 2013, with a sharp selloff in government bonds and a more moderate and temporary dip in equity markets?

In my view, the answer will depend on whether the consensus macro view plays out or whether the consensus once again proves too optimistic. The consensus view is that, despite disappointing growth in 1Q14, the US and global economies remain on track for markedly improved growth for the remainder of 2014 and 2015. This reacceleration in global growth is expected to further reduce unemployment, buoy wage growth and boost inflation from below target levels. If this consensus view plays out, the Fed will continue to taper its bond purchases and will need to consider the timing of the raising the policy rate sooner rather than later. The Bank of England and the Bank of Canada will face the same decision on when and how much their policy rates should rise. The ECB and the PBoC will likely not need to ease monetary policy further. In this consensus scenario, the MOVE Index of bond volatility will rise sharply as it did in the spring of 2013, bond yields will rise sharply. Equity volatility may rise, but not sharply and any dip in the equity market will likely prove temporary.

However, if the consensus view proves too optimistic on growth -- as it has regularly in recent years -- the end of low volatility is more likely to be led by a sharp rise in the VIX Index. In this scenario, stretched equity valuations will come under heavy pressure as the economy fails to provide the profit growth currently built into equity prices. Global equities will face a sharp correction. Government bonds, which have already defied expectations and performed very well this year, will rally further.

How to Protect your Portfolio

Some will argue that investors should use options strategies, which will benefit from a rise in volatility, but unless you are an options expert and a very active trader, such strategies can be difficult and expensive to implement. If you believe that the current period of persistent low volatility will end soon, I believe that there are three possible courses of action to protect a multi-asset portfolio. Two of these courses of action require taking a view on how the current period of low volatility will end. One does not.

  1. If you believe the consensus view will hold, reduce bond exposure and reallocate into cash temporarily. When equities dip, as they did last spring, move from cash into a heavier weight in equities to capitalize on the rebound in equity markets. 
  2. If you believe US and global growth will meaningfully disappoint current consensus expectations, reduce equity and high yield credit exposure and temporarily reallocate to government bonds in anticipation of strong returns from further declines in bond yields.
  3. If you have no idea how the current period of persistent low volatility will end, trim risk exposures across all asset classes, moving temporarily into cash. When the inevitable rise in volatility occurs, it will be possible for the investor to analyze which scenario is playing out and, once it has run its course, where to put the cash back to work. 
Given the uncertainty over when and how the current period of persistent low volatility will end, and the risk of loss if the investor chooses one of the first two option and proves wrong, the prudent choice seems to be the third option. 


Thursday, 1 May 2014

Canadian ETF Portfolios: April Review and May Outlook

Global markets continued to chop around in April providing small gains for diversified portfolios. A modest rally in the Canadian dollar (CAD) versus the USD, subtracted from most foreign currency denominated ETF returns in April.  

  • Global equity markets were widely mixed in April as previously high flying US small-cap and tech stocks sold off sharply while Canadian and European equities posted gains. Japanese equities continued to lose ground.
  • Global bonds were little changed in April, with Canada bonds outperforming foreign currency bonds in CAD terms. 
  • Emerging Market assets were little changed in April, as unrest in Ukraine worsened and EM growth forecasts continued to be downgraded. 
  • Gold and other commodity prices held relatively steady in April after strong gains in Q1. 
  • Energy prices weakened slightly as the WTI crude oil futures price slipped to $100/bbl at the end of April from $101/bbl at the end of March.
  • Global growth forecasts have continued to edge down, led by a disappointing stall in US real GDP growth in Q1.  
  • Global inflation showed mixed signals, with inflation looking as if it might be bottoming in the US and Canada, but still weakening in Europe and Emerging Markets.

Did April, with its choppy activity, provide the pause that refreshes? Or was it the calm before the storm? The Fed continued to taper its QE program despite stalled Q1 growth, lowering its bond purchases by another $10 billion per month to $45 billion. Fed Chair Janet Yellen maintains that policy rates will remain at the current low level as long as slack remains in the labor market. Members of the FOMC remain widely divided on how soon and how much the policy rate should be raised.

The tailwind of a weaker Canadian dollar for Canadian investors in global ETF's reversed a bit in April. Bank of Canada Governor Poloz continues to signal  increased confidence in a soft-landing for Canada’s inflated housing market and no interest in tightening monetary policy. 

Global Market ETFs: Monthly Performance for April

The S&P500 closed April at 1884, up modestly from 1872 at the end of March and 1842 at the end of December. Global equity ETFs posted mixed returns in April. The C$ strengthened 0.7% vs. USD in April, lowering Canadian dollar returns on USD denominated ETFs. Canadian equities (XIU) provided the strongest returns among the equity DTFs we track, gaining 2.2%. Eurozone equities (FEZ) returned 1.6% in CAD terms, while Emerging Markets (EEM) were flat and other equity ETFs posted losses in April, led by Japan (EWJ) -3.0%, and the United States (SPY) -0.1% in CAD terms. US small caps (IWM) returned -4.5%, significantly underperforming US large caps.

Commodity ETFs held on to year-to-date gains in April. The Gold ETF (GLD) returned -0.3% in CAD terms, while the GSCI commodity ETF (GSG) returned 0.2%.

Global Bonds ETFs also turned in mixed performances in April. ETFs with positive returns included Canadian Long Government bonds (XLB), which posted a 1.4% return, the US long government bond (TLH) +0.3% in CAD terms, non-US government bonds (BWX) +0.2%, and USD-denominated Emerging Market bonds (EMB), also +0.2%. Emerging Market Local Currency bonds (EMLC), posted a 0.0% return in CAD terms. 

Inflation-linked bonds (ILBs) posted positive returns in April as inflation showed tentative signs of turning up. Canadian RRBs (XRB) returned +1.4%, US TIPs (TIP) returned +0.5% in CAD terms, and non-US ILBs (WIP) returned +1.1%.

Corporate bonds also provided mixed returns in April as US investment grade (LQD) and high yield (HYG) bonds returned +0.5% and -0.4% respectively. Canadian corporate bonds (XCB) returned +0.6%.

Year-to-date Performance through April

In the first four months of 2014, with the Canadian dollar depreciating 3.0% against the US dollar, the best global ETF returns for Canadian investors were in Gold and US long bonds. The worst returns were in Japanese equities. 

In global equities, the Canadian equity ETF (XIU) performed well, returning 8.0%. The S&P500 ETF (SPY) returned 5.1% in CAD terms. The Eurozone equity ETF (FEZ) returned +6.9% in CAD terms. Emerging Market equities (EEM), suffering from Fed tapering, political turmoil, and China’s growth slowdown, returning 1.9% in CAD terms. The Japan equity ETF (EWJ), hit by Yen strength and slowing Asian growth, returned -6.0%. US small caps (IWM), after a sharp selloff in April, returned 0.0%, underperforming the large cap SPY. 

Commodity ETFs turned in strong performances year to date for Canadian investors, aided by the depreciation of the C$. The Gold ETF (GLD) returned 10.2% in CAD terms, while the iShares GSCI commodity ETF (GSG) returned 6.6%.  

Global Bond ETFs, contrary to consensus expectations at the beginning of the year, performed well in the year-to-date through April. Foreign bond ETFs benefited from currency strength relative to the Canadian dollar and long duration bonds benefited from a combination of weaker than expected economic data and safe haven demand. The US long bonds (TLH) returned +5.5% in USD terms, but with the weakening of the C$, this translated into a +8.7% return in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of +4.9%. Non-US global government bonds (BWX) fared better, posting a return of +6.7% in CAD terms. Emerging Market local currency bonds (EMLC) suffered from the same problems as EM equities, but still returned 4.7% in CAD terms. USD-denominated EM bonds (EMB) returned +8.0%.

Inflation-linked bonds (ILBs) have rebounded the first four months of 2014 after a disastrous performance in 2013. Non-US ILBs (WIP) fared best, returning +7.5% in CAD terms. US TIPs (TIP) returned +6.0% in CAD terms. The Canadian real return bond ETF (XRB), benefiting from its long duration, returned 6.5%. 

In corporate bond space, the US investment grade bond ETF (LQD) returned 7.2% in CAD terms, while the US high yield bond ETF (HYG) posted a return of 6.2% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned of +2.5%.

Global ETF Portfolio Performance for April

In April, the Canadian ETF portfolios tracked in this blog posted modest gains, adding to positive year-to-date returns.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 67 basis points in April to be up 4.9% year-to-date (ytd). A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 50 bps in April to be up 4.3% ytd.

Risk balanced portfolios also posted modest gains in April. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 68 bps in April, boosting to its year-to date gain of 9.9%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 32 bps in April to be up 6.0%ytd.

Outlook for May

Key developments that markets will be watching in May include:

  • Russia's actions in Ukraine have added volatility, but done little damage to major equity markets. Bonds, gold and the yen have benefited from their safe haven attraction. The situation remains a source of uncertainty and a significant geopolitical risk to markets. 
  • The Bank of Canada, with its policy rate decision and April Monetary Policy Report, confirmed that the direction of the next rate move will depend on growth and inflation developments. The economy is on track for growth in the 1.5-2.0% range in Q1, lower than the bank forecast in January. Nevertheless, Governor Poloz remains optimistic and global and Canadian growth will accelerate in the coming quarters. Core inflation remains stuck at just over 1% and is not expected to return to the 2% target until early 2016. Downside risks on inflation may have eased slightly, but the BoC will avoid any talk of tightening.
  • In Q1, US and global growth were weaker than expected. Weather was partly to blame, but US growth, at 0.1%, was a full percentage point weaker than updated forecasts that incorporated the weather effect. Japan’s economy also posted weaker than expected Q1 growth and Q2 is expected to show a contraction in response to the April hike in the consumption tax. In May, signs of clear acceleration across the global economy will be needed to keep the consensus view on track. If the economic data fails to reaccelerate, the resilience in equity markets will continue to be tested. If data suggest a strong reacceleration, bond markets will be at risk.
  • Concerns about low global inflation continue. Recent weak inflation readings in the Eurozone and China support ongoing concerns about global disinflation.
  • Emerging markets remain a focus. China's exchange rate has been allowed to weaken against the USD as Chinese exports and manufacturing activity remain sluggish and housing activity slows. Russia’s economy is suffering from tightening sanctions and private sector capital outflows and is vulnerable to a drop in crude oil prices. Political uncertainty remains in India, Turkey and Brazil. 

To conclude this month’s review, I want to share a quote from from an April 26 Barron’s interview with Doug Kass of Seabreeze Partners Management, a noted value investor. Kass was asked: “What will pressure the [equity] markets?” He responded,

“Disappointing global economic growth, weaker-than-consensus earnings, and a contraction of the price/earnings multiple, compared with a 25% expansion last year. Those will be the culprits for a negative return this year. The consensus view is missing, among other things, the vulnerability of the middle class, which provides an important source of economic growth. It's missing the economic vulnerability of our young people. It's missing our addiction to low interest rates, both in the public and private sectors. It's missing the consequences of higher rates and the risks to profit margins, probably my biggest concern. And it's missing the widening gap between the haves and have-nots—and the economic and social consequences over time.”

Last month, I concluded that the flat market returns in March “may be a pause the refreshes and gives way to better news on growth and less evidence of disinflation in April. That would go some distance toward validating current high equity market valuations, but could bring an end to the surprising bond market rally.”

As it turned out, major equity and bond markets drifted sideways again in April as global uncertainties persisted. Evidence of a pickup in global growth is now badly needed. US corporate earnings growth slowed in Q1, so even the slight gain in the S&P in April pushed equities further into overvalued territory. The risk now is that stronger economic growth reverses the bond market rally and, at the same time, equity multiples reverse. Having ample cash in the portfolio was a prudent strategy in April and remains so in May.