After the dislocations caused by Brexit, volatility went on a European-style summer vacation as the practical implications of Britain leaving the European Union were slow to appear. Now volatility is extending its vacation into the fall and, despite a small resurgence of volatility in September, markets are experiencing a period of relative calm.
However, no matter how agreeable they can be, vacations always come to an end. And in our opinion the period of relative calm we are experiencing hides structural risk that remains in the background.
The first underlying structural risk about which we are concerned is the unprecedented expansion of central bank balance sheets. It creates an environment where interest rates are not set as a function of the supply and demand for capital, but rather related to central bankers’ desire to support short-term economic activity. Such unconventional policies were helpful in the aftermath of the great financial crisis and European sovereign debt crisis; however, they also introduce distortions in the allocation of capital throughout emerging markets.
In economics, humility is a virtue and one should always be mindful of unforeseen consequences of any new economic experiment. While the consequences of these distortions can be slow to appear, it would be foolish to assume that there will be none. The increasing focus of equity market participants on central bankers’ communications underlines the extent to which market confidence is driven by central banks’ policies rather than by the underlying performance of the economy and the capacity of corporations to generate cash flows for their shareholders.
In economics, humility is a virtue and one should always be mindful of unforeseen consequences of any new economic experiment.
In the 1980s, Paul Volker increased interest rates and traded short-term pain in exchange for what—at the time—was an uncertain long-term gain—reducing inflation. With benefit of hindsight, we now know that Volker’s tradeoff worked. Today’s central bankers are taking the opposite tradeoff—short-term gains in supporting economic activity in exchange for long-term risk due to a likely misallocation of capital.1
In addition, as we have been outlining over the last few years, we are witnessing a relentless rise of populism throughout developed markets. While the rise of populism has been very visible in the U.S., it is not limited to the U.S.
In Italy, the former comedian Beppe Grillo’s Five Star movement is now the second most influential political force in the country, running cities such as Rome and Torino. In France, Marine Le Pen will most likely be one of the two candidates in the second round of the presidential election in May 2017. In Eastern Europe, populists are now in power in Poland and Hungary. As the Greek parliamentary elections or Brexit referendum demonstrated, this rise in populism can have very direct and unpleasant consequences for financial markets.
Such risks are not always reflected in the daily markets movement. However, they are present in the background and even though they are not now at the forefront of market preoccupation they significantly impact our market strategy:
- First, we continue to maintain a relatively low-risk posture and a low sensitivity to market systematic (beta) risk
- Second, we took advantage of the low volatility in the summer to add convexity (buying options to gain exposures and/or seeking to establish and maintain protection for our existing exposures) to our strategy—we use these options in an attempt to protect against the downside while maintaining the ability to participate in the upside
- Third, we are looking for opportunities to add value by taking more unsystematic risk and less systematic (market or beta) risk
How We Seek to Add Unsystematic Risk
Truly, unsystematic risk is hard to find. But when opportunities of this nature present themselves, we look to take this type of risk in the portfolio. We add unsystematic risk in an attempt to make our portfolio less correlated with traditional asset classes, which helps mitigate volatility over time and maintains our portfolio’s complementary characteristics with many other strategies.
Recently, we increased our Spanish equity exposure and simultaneously decreased our global equity market exposure. The Spanish equity market is fundamentally attractive and, after a period of political uncertainty, we are seeing more favorable dynamics in Spanish politics. Similarly, we increased our exposure to the fundamentally attractive European financial sector while simultaneously reducing our exposure to broader European equities in a manner that is beta neutral.
But truly idiosyncratic opportunities are hard to find in (asset) markets because the market dislocations that create these opportunities across the investment universe often have a common source. We believe the most reliable source of truly uncorrelated investment opportunities are currencies.
Currency and asset markets are, by nature, uncorrelated and therefore offer numerous potential opportunities to implement exposures that improve our strategy’s risk/return profile. In periods where long-term structural risks make us more cautious with respect to investment opportunities associated with systematic risk, we are looking to increase our exposure to currency opportunities.
1 Thank you to my William Blair colleague Fred Fischer for suggesting to me this divergence in central bank policies.