On the surface, taking a birds eye view of markets, a dormant investor could be forgiven for thinking 2016 has been a very boring year as broader level market indices are mixed across the board. Year to date the S&P 500 is up 7.5%, Eurostoxx 50 down 7%, FTSE up 8.5%, and Emerging Markets up 10.8%. Nothing really to write home about. But boring is an understatement to describe a year that will never be forgotten or when written about, be described with attributes associated with the famous Goliath ride at Six Flags Magic Mountain; scream-inducing plunges, swooping spirals, P&L moving violently around at record breaking stomach-knotting speeds. One would probably enjoy such an adrenalin rush if their stomach would be the only victim rather than their hard earned capital as well.
The Hedge Fund industry faced one of the worst redemptions year to date of $77 billion. Performance is getting more and more mediocre yet fees are still stubbornly too high. There is no doubt there has been a paradigm shift in asset management, some still have not woken up to it. Leverage is the Hedge Fund industry’s cryptonite. Volatility together with extreme positioning with unexpected events such as Chinese Yuan devaluation, Brexit “yes” vote, and Trump being nominated as President-Elect were all fat tail events that occurred in one year. Unexpected events combined with extreme positioning compounded by leverage is a serious recipe for disaster for the wealth management industry.
The Fed’s constant dovishness this year and pushback to delaying interest rate hikes on back of various exogenous events (Emerging market collapse in January, Brexit uncertainty in June, US elections) together with broader Central Bank accommodative monetary policy via constant Quantitative Easing (ECB, BoJ, BOE) forced massive inflows into Bonds as the search for yield continued as investors confidently echoed the mantra of “lower for longer” rates. “TINA” was quoted everywhere from sell side to media reports as investors claimed “there is no alternative” as the basis to justify investing into any yielding securities, despite the low returns they offered. In July’16, a Bond investor was paying the equivalent of 0.5% to Germany for holding their money for five years! In October’16, the Italian government issued its first sale of ultra-long bonds at a yield of 2.8% generating 18.5 billion Euros worth of orders on a 5 billion Euro sale as investors shrugged off political uncertainty and a troubled banking system only in search of any positive yield available in the market. Call me a cynic, but doesn’t one invest in Bonds to “earn” a coupon or a dividend?
According to a Barclays report in August 2016, around two-thirds of the broader Bond markets was in negative yielding territory. Usually a bad sign when one invests out of desperation. As the yields moved lower, pensions funds faced the uphill battle of offsetting their asset vs. liabilities mismatch as yields grew further in negative territory. It was a disaster waiting to happen.
The US Economy had been more or less on a solid footing this year. The Fed was just too “scared” to raise rates even though break-even inflation rates kept pointing higher with employment and wage growth showing signs of stability. Their logic was once they started to raise rates, there was no turning back. This compounded the problem at hand even more. With the broader economic data picking up, the risk reward seemed favourable to short US Bonds especially as the data called for higher inflation prospects.
Bonds started retreating in September as FOMC tilted towards a December rate hike bias. The US November election results reset the Bond markets further when Trump announced an infrastructure boost and a desire to impose tariffs on goods imported from Asia, all in a bid to “Make America Great Again.” As idealistic as it sounds, there is no way the US economy can produce goods cheaper than China or rest of the world. Trump’s fiscal spending boost together with tax cuts and tariffs implied a future of higher inflation ahead. Bonds had no choice but to sell off.
Risk parity funds who work on balancing their Bond vs. Equity exposure are in “theory” supposed to see an equal uplift in Equities to offset Bond losses. However this time around, they were hurt as Equities did not gain enough to offset sharp sell offs in Bonds as these funds are typically exposed by four times as much as Equities. Unwinds can be nasty especially when moves and positioning changes so aggressively. Risk limits blow up and compels fund managers to liquidate across the board, exaggerating moves in all asset classes.
Have we just normalised all the recent extreme views to price in an inflationary world we will be living in going forward or is this yet another opportunity to capitalise upon? That remains to be seen once. Well at least until investors are done licking their wounds.