June and early July was a good period for equities and high yield bonds and, therefore, for our mandates and funds, since they all hold their maximum exposure to these asset classes. With US equities and especially Nasdaq performing well, our strategies benefited in particular from exposure to these markets. Our allocation to high yield also helped the Global Fixed Income Opportunities strategy (GFO), where this is the dominating asset class. In our Euro mandates, open USD positions also helped performance. This is more of a residual effect since we mainly hold these open currency positions for their diversification and risk dampening effects (in USD and CHF portfolios we are fully hedged). This is especially important during market sell-offs, and such risk events should always be kept in mind; also when markets reach all-time highs and things looks calm and easy.
Regarding the question of where to invest cash, our first proposal related to investors who are generally invested along with their long-term strategy, but additional have cash which is now facing negative interest rates. It also apply to those who used to get a positive return on their government and investment grade bonds, but have seen negative return recently. For these types of investors, we developed the GFO strategy. With its dynamic allocation this strategy offers a realistic chance of getting a return above inflation and growth in stark contrast to cash holdings and many Euro and CHF bonds with low or negative yields. Our GFO mandates and the ACCI GFO fund have been operative since March 2019. It has already shown that it can perform well both during recessions, and during economic recoveries and bull markets, with rallying equity and credit markets. Reflecting this the fund is up 10% year on year. However, until we get the next market upheaval, annual returns are likely to be closer to 5%. Towards the end of this publication, we bring an update of our analysis showing why the current US administration led by the Treasury secretary Yellen is likely to continue supporting credit markets.
Figure 1: The US S&P 500 has returned 11% annually and an aggregate of 3,300% since 1988
While markets were relatively calm in June, the air seems full of anxiety. Some commentators claim the end is near for the equity market rally. Some FOMC members seem to think that it is a good idea to talk about rate hikes and a QE roll back to cool the housing market; and some investors seem frustrated that they hold cash that yields nothing, or crypto currencies which have now reminded everyone they can move down in value as fast as they can move up. In periods like this, it is useful to take a longer term perspective. As seen in Figure 1, the positive trend in US equities goes back decades. There have been large setbacks, but even in the event that you had invested at the peak of the markets in 2007, the returns of US liquid equities have been 7%-8%. This is in line with annual returns since 1900.
These are very compelling returns, but they come with corrections of 50%+ from time to time and equities are close to all-time highs and MSCI world is up 38% YoY. In this context stepping into the market with cash right now can look risky or dangerous, our answer to "what to do with cash" depends on investor experience, risk aversion and investment horizon. For the "normal" investor who would have held a 30%/70% or 40%/60% Equity bond portfolio, our recommendation is to look at multi-asset strategies like our "Diversified" portfolios. For investors looking for equity market exposure we recommend the Systematic Equity Allocation strategy. Their main advantage from a risk management perspective is that they both have the potential to move fully out of equities before or during a prolonged recession, and the decision will be supported by algorithms, potentially saving both financial and emotional hardship.
From a conceptual perspective, the SEA strategy can also work as a cautious or defensive opportunity for investor already in equities, who wish to shift from outright equities "long only" positions to a more active risk management framework and can therefore help "multi-manager" portfolios to achieve a higher degree of activity and a more defensive profile. This works via clear criteria as to which conditions will lead to an exit from the market, and even more importantly, in respect of how to get invested again. We return to the drivers of these decisions on the following page. Before that we provide the usual overview of our positioning:
We maintain a 100% equity allocation in our Systematic Equity Allocation Strategy, significantly above the long-term balanced level of 60%. The strategy is up 14% year to date and 38% year on year and the ACCI SA fund is in the top 10% of its peer group year on year and year to date.
In our multi-asset mandates and funds, we maintain the full allocation to equities and the enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios are up 7-9% year to date and 20% year on year.
In our Global Fixed Income Opportunities strategies and funds, we maintain our high yield bond positions. These portfolios are up 2% year to date and 10% year on year.
What is driving markets
Some commentators portray the rise in equity markets as the consequence of mainly multiple expansion and financial engineering. These factors have played a role in the last 30-40 years particularly, but they are not the only factors having lifted the S&P total return since 1988 to above 3,000%. And more so, they have not delivered the continuous doubling of the capital invested in US equities roughly every decade for the last 120 years. The S&P 500 trade at 22 times full year 2021 earnings and halfway through this year, these earnings are more likely to be adjusted up than down. So, for this year, as for the last 120 years in aggregate, equity market return look to be closely linked to the real economy via earnings growth, assisted but not dominated by financial conditions. (We will return to the merits of financial engineering in later publications, but it is not such a bad thing).
The importance of prices and earnings, has over time led many people to claim that the only honourable investment discipline is value investing, or that markets are efficient. A reference is often made to Warren Buffet, but as his intense use of leverage has become clear to more and more people, and his performance has become more "human", the story has become less straight forward (one of many great, but sometimes misunderstood man and woman in history). The same holds for the old, but still theoretically very unconvincing idea that markets are efficient. One of the problems with the idea that markets should be efficient is that it is then very difficult to explain why people buy and sell, especially when some must be very wrong whenever someone is very right with their timing. In general observable phenomena like price fluctuations, market rallies and collapses and simple human feelings such as fear, confusion, confidence, ambition all become very difficult to fully explain. One can assume these do not exist in markets, but to us it seems easier to work with these factors and code then into our algorithms than to work as hard as some believers in the efficient market hypothesis like the "Chicago School of Economics" have done to keep the hypothesis alive.
Looking at developments in the shorter-term earnings play a much smaller and often lagging role, and finical conditions dictated by central banks often dominate along with emotional factors and biases, often described together in the term behavioural finance, is much more important. This holds especially when the investment horizon is a few months, a quarter, or a year or two. In our case, we are therefore using earnings as a one of the "slower moving" or "lagging" indicators in our algorithms. As we mentioned last month, the figures of earnings for 2021 had not yet been adjusted upwards after the blockbuster Q1 2021 earnings season. These adjustments are now starting to come in. Thus Q2 2021 earnings growth is now expected to be 65% year on year and Q3 2021 earnings growth 24% year on year. That way, the stronger than expected earnings recovery is also one of the reasons why our algorithms remain in very positive territory. As a recent reference, the situation was much the same in 2016-17. Just as then, we also now remain fully invested in equities up to the limits allowed in our strategies.
Other factors that help to explain why equity markets have been performing so well are investor confidence and comfort, the return of supportive momentum in the credit markets, where things had swung from supportive to contractive, as yields in the second half of 2020 and the first months of this year. The strong cyclical position of the US economy also supports the high level of the algorithms.
Figure 2 shows our algorithm for the Business Cycle Trend. It looks rather unstable and slightly confusing, but it must be seen in relation to the poor statistical quality of data like the non-farm payroll, retail sales and industrial production. The algorithms usefulness further has to be judged relative the problems with the human memory, the technical difficulties with inter-temporal comparisons of multi-variable correlations in the human brain, and the associated high uncertainty there is in terms of consistency and precision in analysis of macro variables carried out by economists and strategists (even if they use econometric models, which tend to be very simplistic) With the best of intentions, of course. For us, good intentions are not good enough and we therefore prefer unbiased algorithms to do the heavy work of both remembering and calculating absolute and relative strength and momentum in macro data.
Other important factors are market momentum and volatility, as these represents technology trends optimism, exuberance and nervousness and panic probabilities of market themselves. When we initially started working with finance more than 25-years ago such references to market themselves were at risk of being frowned upon as technical analyses. Nowadays there is a better understanding of the importance of herd behaviour, greed and fear, and the spread of panic and trends driven by media and social narratives. This understanding now falls under the somewhat overlapping terms of behavioural finance and behavioural economics.
Figure 2: The US business cycle remains strong as reflected in our business cycle momentum algorithm.
We capture these trends in algorithms such as the one shown in Figure 3. The aggregated result of our algorithms is shown on the last page of this publication. Their signals have not changed much. For the time being, we remain fully invested. If the algorithms change across their respective thresholds, we will change our positions accordingly and decisively.
Figure 3: Market momentum algorithms for risk management and portfolio positioning
The Federal Reserve has changed its message, but it cannot change the context
As the supercharged recovery gains traction, the limits of rates that the economy can handle go up, but they do not disappear, and new worries appear. Naturally enough, in the second year of the recovery, markets are now facing inflation concerns. According to the June FOMC meeting, the FOMC themselves expect the Fed Fund rate to remain close to zero for the next two years and move up gradually in 2023. However, after the FOMC meeting, an influential minority is now talking about uncertainty and a possibility of lift off in 2022. Additionally, there is talk of tapering mortgage bonds relatively faster than government bonds (same absolute taper). Independently of such a view, we still think the FOMC is guided and constrained by the following dynamics:
The Fed under Powell and the Treasury under Yellen prioritise a strong recovery and growth above inflation concerns, not least because of Yellen’s unusually strong economic and monetary policy credentials and her long standing alignment with what is now the policy of many Democrats.
Allowing US interest rates to move up will hamper the recovery and a quick and large further increase will most likely hurt the very people the Fed and the Treasury now wish to help.
The Fed brought rates down so far in 2020 that companies and consumers loaded up on debt, so that increasing interest rates will have a larger than usual tightening effect.
US government debt has ballooned. Even before more fiscal spending is administered, the best, and possibly the only way to manage this debt will be to hold interest rates well below the nominal growth rate of the economy and preferably a few percentage points lower.
As government bond yields gradually drift higher, the Fed cannot let mortgage spreads go up much because the first to be hit by such additional tightening will be the most vulnerable groups which Powell has now committed to help.
Spreads on corporate credit are unlikely to move back up to the levels seen even two years ago. If they do, too many corporate borrowers will have to de-leverage or might not be able to pay their debt.
The Fed cannot easily let high yield bonds find their “independent equilibrium” because the process from an “assisted equilibrium", as created by the actions of last year, towards an “independent equilibrium”, is volatile and unstable and high yield is the gateway to equities.
Equities are the largest store of value for the US consumer outside of housing, so an equity market collapse would be putting both financial stability, growth, and the goals of increased equality at risk.
For the time being, the above targets are only implicit and not declared and defined, but it is likely that both the yield targets for government bonds and additional credit market support will become explicit if things start to unwind. During the next recession we will most likely see outright purchases of both investment grade credit and high yield bonds and potentially equity purchases. After all, each of the three latest recessions has seen the Fed intervening in the markets in a greater volume and to a wider extent. Until such events occur, the most likely path forward is a continued QE and a volatile, but gradual, movement of the US 10-year rate to a level around 2.5%-3.25%. However, with a higher inflation target, the real yields would still be below the recent peak.
Mads N. S. Pedersen, Managing Partner and CIO