Yield normalization, central bank control, and market volatility

Two months into the year, equity markets have already been through two rounds of swift sell offs, with technology taking centre stage. Even so, the real drama has been in the government bond market. For more than half a year yields have moved up gradually. At the end of February, Powell reported both to the Senate and to the House of representatives, emphasising the need for a continued supportive monetary policy to reach full capacity. In his carefully prepared remarks, Powell avoided commenting on the upward move in yields and thus possibly accelerating the movement with was already driven by stronger than expected macro data and declining infection rates. In this way the sessions in Congress probably helped to create the conditions sending the US 5-year to yield to it second largest spike in a decade and the 10-year yield above 1.5%. As shown in figure 1 this is three times the level it bottomed at last year and markets again woke up to the old themes of convexity hedging and the uncomfortable fact that "the duration" of stocks is longer than that of most bonds, especially growth stocks, as payments are perpetual in nature.

As market have again calmed down, two things clearly emphasised by Powell will be very important for the coming years (original quotation marks and italics shown here). On the one hand, the Fed's decisions will be informed by their "assessments of shortfalls of employment from its maximum level" rather than by "deviations from its maximum level". On the other hand, he again made it clear that the goal is to “achieve inflation that averages 2 percent over time. This means that, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time”. The two formulations are comfortably within the script followed by Powell and Treasury Secretary Yellen with their continued emphasis on how much positive influence a lasting and strong recovery can have on the economy and especially on the less fortunate and "minority groups" (a term often used by Powell).

Figure 1: The recent spike in US bond yields was dramatic, but levels are still low

Nominal losses in government bonds have until now been limited to single digit levels for the most important duration buckets. This is still enough to warrant attention both because this is the first of many likely wobbles in markets and because it already set of verbal intervention from the ECB and actual buying from the Australian central bank. It also showed just how fast the stress can spreads to equities. The fundamental reason behind this chain reaction is that the US dollar remains the global reserve currency, a position it continues to hold as firmly as any other time in recent decades. The price of USD from cash rates to the 30-year maturity is therefore still "the pricing anchor" globally for everything in financial markets and beyond and the more leverage in the global system, the more important this anchor becomes.

The dynamic and self-reinforcing movements of markets and the economy make each interest rate adjustment episodes complicated and challenging to understand, but what seems clear is that if central banks "set markets free", we will quickly dive into the next recession. In the following we will therefore be updating our analysis of the state of the market and the balance the Fed and other central banks are striving to strike. What we show on the following pages is a snapshot of how individual markets are pricing liquidity and credit. For example, how the yields on high yield bonds and on investment bonds remain about 200bps below the level seen when the Fed started easing policy in late 2018 (please see Figure 2). A larger upward movement in these yields would mean tighter credit conditions and thus, due to the dynamic links to the economy, would also signal an increased probability of the Fed intervening in these markets verbally or, if needed, directly. At the same time market confidence is underpinned by a strong Q4 2020 earnings season, in which the expected year on year growth has been revised up from -9% around the turn of the year to a positive 3%. In our investment process we use this date in its aggregate form expressed in our algorithms, which constantly keep track of the dynamic development and the absolute and relative importance of input factors. For the time being, the signals from the algorithms are positive (see the last page of the publication) and we therefore maintain our "Positive" positioning across multi-asset and fixed income portfolios. Specifically, across the strategies, we hold the following positions:

- In our Systematic Equity Allocation strategy, we maintained our 100% equity allocation, which helped us capture the move up in the market through 2H of 2020 and into 2021, and led our ACCI SA fund to move into the top 10% by year on year performance in the Bloomberg Dynamic Allocation classification.

- In our multi-asset mandates and funds, we maintain a full allocation to equities (50%-60% depending on restrictions) and an enhanced 30% allocation to high yield bonds with duration around 3 years, where we expect an additional tightening of USD spreads of 40-60bps in the remainder of the year.

- In our Global Fixed Income opportunities strategy, we hold mainly high yield bonds supplemented with smaller positions in emerging market debt. With a duration slightly above 3 years, the strategy and the associated fund have avoided most of the duration-induced losses in fixed income markets year to date.

Portfolio Review

This last year has in many ways been exceptional, not least because of the pandemic and the associated actions that have been taken. As equities peaked in the second half of February and a year has passed since then, so it is a good time to review how our strategies have fared through the recession and subsequent recovery. In Figure 2 we compare the recent years to the period since June 2015, when we started managing money with a fully dynamic allocation process at our previous employer. It can clearly be seen that this time around our timing in terms of risk reduction was less fortunate than in 2015 when we were at the lowest risk level when the correction happened in August. The obvious reason is in the events of 2020, things went from normal to lock down too quickly for us to react in time and we only reduced risk in early days of March. As seen in Figure 3, the shift from 100% to Zero equities in the SEA strategy reduced the drawdowns significantly compared to the MSCI world and the 60 equity/40 bonds benchmark, but as opposed to 2015, it did not prevent a larger than desired decline.

Figure 2: Performance of the SEA strategy vs. its 60%/40% equity/ bond benchmark (live date starts April 2019)

We have since increased our efforts to capture such events timely and would now expect a faster exit, although it should be noted that our process targets gradual changes and deteriorations, not a sudden calamity. In recent years we have developed a dynamic application of the algorithms which allow us to enter markets earlier than with the models we used in 2015. Even so, we missed out on the first weeks, entering in two steps in late May and late June.

Investment horizons do not end with the end of a recession. One of the major temptations that our investment strategy is set up to counter is the desire to realise a gain, but as seen in Figure 1, both in 2016-17 and in the 8 months since the middle of 2020, it may be worth maintaining an investment in equities and letting positions run as long as conditions are favourable. In our Diversified strategies we hold a maximum of 50% or 60% equities dependent on the risk limits, with the remainder in invested in bonds.

Figure 3: Maximum drawdowns of the SEA strategy and MSCI world

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