In late August, the centre of attention for the financial world turned to the Kansas Fed's annual Jackson Hole conference. At the virtual gathering, Powell delivered an elegant speech which we would recommend anyone to read as it gives a smooth and well-rounded reasoning for the policy communicated and executed by the Fed during the past year. The main conclusions are not new. The Fed has gradually communicated that it is likely that we will see a tapering of QE later this year and that rates will most likely be raised next year at the earliest. Given the effort in arguing that inflation should be expected to move down again, the most important message in the speech is therefore implicit. And even more important, if inflation does not abate in 6 months, it should be expected to moderate later. This implication is that according to the Fed Chairman and his team, the best policy is compassion, patience, and bond purchases.
For markets, this also means that independently of what is driving the prices of equities, houses, art and other assets, the current policy is seen as appropriate and that things should be allowed to continue without the Fed rocking the boat. This also means that the sell-off in government bonds, which has been on hold since April, may resume and continue. In this context, the decline in longer dated rates seen since Q1 of this year is, in our opinion, nothing more than a natural pause in what we expect to be a long journey for the US 10-year yields back to a level around 2.5% - 3.5%. The level at which we expect the 10-year yields to peak in this cycle. If the Fed manages to stabilize inflation around 2%, this is also the equivalent of 0.5-1.5% real rates. From the perspective of political values, Powell was also re-iterating that this is the morally correct policy, as many of the ones who lost during the recent recession have not yet made it back into jobs on a comfortable and sustainable basis. While the bond yield increase this year as shown in Figure 1 are moderate, the long duration of the market has in many cases made the lives of fixed income managers painful. This is illustrated in Figure 2, where we show the returns of US Treasury and the aggregate bonds over the last year compared to the returns of the GFO strategy and the ACCI fund.
Figure 1: US government bond yields. The re-pricing may resume
In our view, the pain is likely to resume and possibly become more acute if the Fed gets its way with things. So, many fixed income investors will need to decide if they want to continue to bet against the Fed, as many have done since last year, although the might not think of it this as they are often sticking to their benchmarks or mandate.
In practice, no severe damage to the housing market or the equity market will be tolerated and therefore the expected normalisation of yields requires a gradual process. This has led some to think that the Fed alone has lifted equity markets this year. We don’t agree. According to our algorithms, the main support of strong markets this year has been earnings and favourable earnings surprises. In addition, this development is also lending credibility to the belief that the way out of global problems is via innovation and new technology. There is something positive and refreshing about this idea. It is also the only story in town which unites the left and the right wing in politics. In terms of numbers, earnings momentum remains at the capped out maximum level of 1 in our algorithms. The direct stimulus from monetary policy is best captured via the credit market, where we in recent years have adjusted the way we look at spreads as opposed to total yield level. This has lead to a faster reaction of the algorithms to changes in monetary stimulus driving financial markets. In addition to this change, we apply new filters, data handling, and an additional methodology for multivariable optimization. This means that whereas in 2016 we had one algorithm, we now have a technology platform with systems for constructing, testing and managing portfolios integrated with our "algorithm factory". Still, we do not "rely on a machine", but rather work with a technology platform to help us enhance the consistency of our decision-making processes, as an integral part of the way we manage portfolios.
With earnings momentum and credit conditions supporting equity markets, we maintain our 100% equity allocation (40% overweight) in our Systematic Equity Allocation Strategy. We also maintain a large bias towards US large cap and significant holdings across the technology sector via both S&P 500 and Nasdaq positions. The year-on-year return is 31%. The year-to-date return is 15%. The associated ACCI SA fund is comfortably in the top 10% of its peer group. Towards the end of this publication, we show the updated version of our Sustainable portfolio and how it has outperformed MSCI World.
Fed Chairman Powell doubled down on the justification for a normalisation of inflation and an easy monetary policy. We expect the US 10-year yield to move gradually towards 2.5%-3.5%. In this scenario, high grade bonds will continue to suffer. We maintain our high yield bond positions across our global fixed income strategies. These strategies up 2.4% year to date and 6% year on year.
In our multi-asset mandates and funds, we retain the full allocation to equities and the enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios are up 12%-17% year to date and 19%-23% year on year, all dependent on risk level and currency.
How stimulative is the Feds policy?
Figure 1 shows the level of US interest rates and according to this interpretation we are close to maximum stimulus. However, the timing of monetary policy moves, and interest rate level dynamics also matter, so does the flow of QE and the level and dynamics of credit spreads. When we started working in finance more than two decades ago, the yield curve was considered the main signal for the dynamic link to the economy. But it only worked as a signal from the market to economists and strategists as to what the economy would likely do. It does not tell you much about reverse causality or about markets themselves (except that everything collapsed in two rounds in 2000-03 and 2007-09). Over the last two decades, therefore, we have put considerable effort into understanding these dynamics. Our work started with the simple observation that credit managers have a tendency to be more realistic about cyclical turning points than equity managers, who on average are too optimistic across the cycle, indicating that the credit market and liquidity matters for equities also forward and thereby that markets are not pricing in all information right away. One of our first indicators was based on changes to the level of the federal funds rate. It worked well for a few years but became obsolete when Bernanke started doing QE and short rates flatlined. From the beginning of the last decade, we changed to using credit spreads dynamics: a broad and very useful measure. However, as our current CTO built a new and more dynamic investment platform and the aforementioned integrated system for algorithm construction, we were able to improve the signal significantly by shifting from exponential averaging to more advanced measures and to add new variables. This has led us to include spreads, yield, and total return dynamics. As a result, we capture better and faster the impact of monetary policy and the credit cycle on equity and credit markets themselves. Consequently, we now have a measurement between minus one and one of monetary credit conditions, with the current reading being a comfortably supportive 0.5 on the algorithms currently used in our funds, and close to zero (neutral from an equity market point of view) in the slower moving version of our algorithms, which tend to capture short corrections less well, but perform better in major crises like 2007-09.
Figure 2: Return on US government and credit bonds vs. the ACCCI GFO fund.
With this relatively high level of stimulus and given that the Fed has made it clear that they are patient and markets have priced it in, the re-pricing of long duration bonds is likely to resume and our view remains that the
Figure 3: Total return of the US aggregate index vs. the GFO strategy
new peak level will be somewhere around 2.5%-3.0%. So that is where we expect US rates on the 10-year to be heading. All we need is a continued, strong recovery, composure, and that the Afghan situation does not spiral out of control.
Figure 4: Max drawdowns of the US aggregate bond market index vs. the GFO strategy
In Figure 1, the movement of the 10-year yields up to and above 3% in 2013 and 2018 looks like a smooth process. Going back in time the Global Fixed Income Opportunities and the US Aggregates bond index shows that it was far from being a smooth process for the US bond market investors. From 2016-18, the aggregate market as expressed in the ETF US Agg bonds delivered no return. Only when the Fed started talking about and enacting actual easing in late 2018 did the market deliver a decent return. This Fed easing helped the Agg index to deliver a return of 2.8% over the past 5 years. But this is in nominal terms, so the real return is close to zero over the last 5 years, with the exact number depending on the inflation index measurement you may prefer. Looking ahead, it is difficult to see the Fed delivering much, if any, additional stimulus. With rates at current levels, it is therefore most likely that returns for investors in the aggregate index will be close to zero, with large downside risk and substantial drawdowns.
Returning to the positive optimistic view that the world, or at least the environment, could possibly be saved via innovation and investments and not only through restraint. We have updated both our Sustainability Matrix and the return calculation for our Sustainable equity strategy (the "Positive" 100% equity portfolio in our Edge
Figure 5: Total return of the EDGE Sustainable Strategy vs. MSCI World.
Sustainable portfolio). We will return with a comprehensive update on the methodology and the matrices, we use. For now, we want to highlight that the strategy continues to perform well. Shown as the black line in figure 5 combine, it the strategy combines 6 ESG and SRI ETFs and have performed in line with the S&P 500 since 2015. Assuming trading costs, instrument costs and management fees, the strategy is up 153% since the beginning of 2015. MSCI World iShares is up 111% and the S&P 500 iShares 149%. Applying our systematic allocation methodology reduces volatility by approximately a third while limiting drawdowns to less than 15%. This is particularly relevant when one is investing into strategies with a high concentration of growth and technology stocks. This type of portfolios naturally leads to a bias towards stocks which suffer large losses in recessions and market corrections where enthusiasm and believe in the future turns into fear and scepticism.
As illustrated in Figure 5, the dynamic strategy called, EDGE Sustainable has outperformed in comparison with both MSCI World (the grey line) and the static 100% Sustainable Equity portfolio (Edge Sustainable delivered 191% total return after cost and fees). This performance is achieved while having a carbon footprint of less than half the usual approximately 130tons pr 1m USD turnover, seen in equity portfolios, and with a majority of individual equities rates AAA and AA on the well-established MSCI score. This way our Sustainability Matrix allows us to consider both the important Co2 concern and also include a comprehensive methodology for qualitative and quantitative assessment of which companies are ESG leaders and laggards and which companies and ETFs have a positive or negative ESG momentum.
Mads N. S. Pedersen, Managing Partner and CIO