By Nicolas Gaussel
Sailors and mountaineers know it: weather can vary all of a sudden and change a nice family journey into a dangerous endeavor. This has certainly been the case for markets as storm clouds gathered following a largely positive first quarter of the year.
Since April, 10-year bund yields soared unexpectedly, generating an unprecedented loss in value of 8.3% in less than two months; the Grexit drama came back to haunt investors and policymakers; concerns arose over China’s foreign exchange regime; and uncertainties over the Fed’s stance caused unprecedented movements in equity markets. Over five trading sessions (17-24 August) the S&P 500 suffered a 10% drawdown, a highly unlikely event that has only happened on few occasions over the last 50 years. At the same time, the VIX Index jumped from 13% to 41%, a rise the extent of which has never before been seen, even in the wake of the Lehman fallout.
DESPITE MARKET WORRIES, GLOBAL GROWTH SHOULD MAINTAIN ITSELF
There are fundamental weaknesses that justify these market jitters: economic recovery in Europe and in Japan is weak; large emerging markets are experiencing severe growth deceleration; deflation risks remain significant across the board. In the US, the Federal Reserve will have to reverse an unprecedented accommodative stance at some point, while US equity valuations are historically expensive.
This said, the positive developments on the US recovery front will likely outweigh the negative implications of the above, at least in the medium term. Recent data shows the US economy grew 3.7% in Q2 2015 with private consumption proving particularly influential, a scenario likely to continue on account of lower oil prices. The US labour market is vibrant, with unemployment in September having reached 5.1%, a level that seems out of reach to many European countries. The real estate market is also upbeat, with existing home sales reaching their pre-recession pace recently.
Elsewhere, we remain overweight European and Japanese equities as valuations remains attractive in relative terms. However a neutral stance on fixed income is advisable due to expensive valuations, despite the low growth environment and deflation fears being somewhat supportive.
THE CASE FOR HEDGE FUNDS AND RISK BUDGETING STRATEGIES
While the outlook may be brighter, careful thought is still needed as to where investors allocate in order to secure returns. In such an environment, we believe there is a particularly strong case for combining risk-budgeting and alpha strategies to secure long term returns.
From an alpha perspective, hedge fund strategies have proven very resilient this year with equity L/S and global macro managers particularly doing well. This has been noticed by investors, with inflows into liquid alternatives in 2015 reaching record levels in Europe (EUR50bn between January-August 2015) on account of their attractiveness relative to traditional approaches and hedging capabilities.
The case for risk budgeting strategies is more complex and needs to be considered in a long term context. Such strategies have come in for considerable criticism recently, with some commentators claiming they have contributed to downward market movements. Such analysis is not correct. If most risk-budgeting managers indeed use volatility as a proxy for risk, they typically use a 3M to 1Y average volatility, which tends to smooth the deleveraging process of such strategies. Meanwhile, the criticism on their disappointing performances recently neglects the overall purpose of these strategies, which is to deliver long term risk-adjusted returns. It is unrealistic to expect risk budgeting strategies to escape short term global market sell-offs, particularly if these strategies are long only. Even then, most risk budgeting approaches still deliver returns above traditional balanced funds as they gradually reduce their exposure as long as market risk increases. But it is on a longer term view that the properties of these strategies come to the fore, with detailed academic analysis and simulations showing risk budgeting strategies have performed extremely well in the various market scenarios experienced since 1980.
While difficult, it is therefore important that investors keep such short term market movements in perspective and maintain an eye on the longer term horizon. The case for risk budgeting strategies in such a context remains strong, with a portfolio that combines these solutions with alpha driven hedge fund strategies offering an optimal approach to deal with short term issues.
Nicolas Gaussel is CIO at Lyxor Asset Management
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