Macro and Credit - A shot across the bows

"History is a vast early warning system." - Norman Cousins, American author

Looking at the markets wobbles on Friday, with the ructions taking place in various asset classes with continued pressure on bonds, there were nowhere to hide except maybe cash in US dollar, so we reminded ourselves for our title analogy of the phrase "A shot across the bows" given our fondness for maritime analogies. Admiral William Smyth, the author of the 1865 book "The sailor's word-book: an alphabetical digest of nautical terms, defines the bows as follows:

"The fore-end of a ship or boat; being the rounding part of a vessel forward, beginning on both sides where the planks arch inwards, and terminating where they close, at the rabbet of the stem or prow, being larboard or starboard from that division". 

"A shot across the bows" derives from the naval practice of firing a cannon shot across the bows of an opponent's ship to show them that you are prepared to do battle. But, the more general figurative use of the expression, just to mean warning. During the 18th century, a warning shot (in nautical terms, called "a shot across the bow") could be fired towards any ship whose "colours" (nationality) had to be ascertained. According to the law of the sea, a ship thus hailed had to fly her flag and confirm it with a gunshot. The latest nonfarm payroll number with U.S. Average Hourly Earnings rising 2.9% Y/Y, the most since 2009 against expectations could be perceived as the shot across the market bows we think as the markets are starting to feel the threat of inflation expectations building up which would mean a more aggressive hiking stance from the Fed. After all the last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan. On this very blog we warned in numerous conversations about the risk for "balanced funds" getting "unbalanced" due to rising positive correlations thanks to central banks meddling with volatility and interest rates. At the end of August 2016, we were reminded how stocks and treasuries could move together. We had the same pattern following the surprise Chinese Yuan devaluation in August 2015 as well. The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield, that simple. In this repeated scenario we saw on Friday, the diversification benefits of a traditional 60/40 (stocks/bonds) portfolio disappears, yet another shot across the bows, as in 2015 and 2016. 

In this week's conversation, we would like to look at the recent sell-off thanks to rising positive correlations rendering once again balanced funds unbalanced. Instability thanks to rising positive correlations have been brewing in recent years. We have discussed this problem in numerous conversations (as pointed out in our short August 2016 conversation "Positive correlations and large Standard Deviation moves").

Synopsis:

• Macro and Credit - Is the luck of "balanced fund managers" about to run out?
• Final charts - The "Wealth" defect

• Macro and Credit - Is the luck of "balanced fund managers" about to run out?

Back in February 2016 in our conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool, we argued the following:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

Once again, the correlation between macro variables in recent months have gone in concert significantly in recent months as highlighted by Deutsche Bank in their Asset Allocation note from the 31st of January entitled "Stretched Consensus Positioning":

"Has the fever broken?

Whatever the fundamental case for each of these trades, extended positioning argues at a minimum for a breather and more likely a pullback soon. Moreover, the tight correlation in the moves across the major asset classes (oil up, dollar down, equities and bond yields up) suggests a pullback in one for idiosyncratic reasons would likely spill over to the others. There are several potential fundamental catalysts for a positioning unwind although cases of extended positioning do not always require one:

■ Oil looks most vulnerable from the vantage point of positioning. While it has been supported by a series of positive factors, a turn in any, especially a lagged increase in supply as is typical after periods of rising oil prices, risks a sharp positioning unwind.

■ A rise in the dollar has potentially the widest fundamental impact across asset classes. Arguably its depreciation has been an important driver of the run up in oil prices to which breakeven inflation and bond yields have been well correlated. The decline in the dollar and higher oil prices have been a significant positive for equities but in our view not the most important as the drivers of the rebound in earnings have been very broad based (Very Strong Earnings Growth Before Tax Reform, Jan 2017).

■ Equities while vulnerable to a positioning unwind have seen very little in terms of inflows. Recent inflows look largely to be a catch up for prior outflows. In particular US equities have seen almost no inflows cumulatively since the start of the 15-month rally.

■ Short positioning in rates is at an extreme and vulnerable to a pullback but bond valuations remain in our view completely out of line with growth, reflecting weak inflation which we expect to turn up. If inflation fails to pick up, the large short positions are likely to be unwound and rates turn lower in turn, as happened last year. Our house view remains a gradual rise in inflation which supports the large short positions and would allow for a continued orderly rise in rates. This will have implications in our view mainly for the bond market which has enjoyed the bulk of inflows through the cycle and to which end investors remain massively over allocated. However the risk is that with all 4 fundamental drivers of inflation pointing up, a move in concert has the potential to create a sharp pickup in inflation which is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle, resulting in broad based risk aversion." - source Deutsche Bank

Positive cross-asset correlation  and balanced funds getting "unbalanced" is a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out. We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead. In similar fashion to CPPI strategies, Vol Control funds (representing close to $200 billion) must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds". Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop.

In our "investing book", these strategies are indeed directly impacted by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear readers to the guest post from our Rcube friends which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":

"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."

Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.

However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013

We still could not agree more with our friends. This risk is still valid today and it got even more "crowded" in recent years.  One should always pay great attention to rising positive correlations as they portend some pull-back eventually with no one truly spared. 

When it comes to market jitters and flows, the High Yield ETF crowd, mostly made up of retail players continue to be feeble when it comes to exiting the party when the heat is on. Bank of America Merrill Lynch in their High Yield Flow report from the 1st of February 2018 entitled "HY outflows accelerate" continues to point towards the nervousness of the retail crowd:

"US HY sees large outflow, EM debt and high grade gain

Outflows from US HY funds totaled $1.39bn (-0.6%) last week, accelerating from $838mn and $938mn during the previous two sessions, respectively. Most of the outflows continue to be concentrated in ETFs which experienced a $1.02bn (-2.1%) redemption last week, whereas open-ended funds recognized a $375mn (-0.2%) withdrawal. These most recent outflows completely wiped out the $3bn in gains during the first two weeks of the year, sending the YTD total to -$188mn. HY funds domiciled outside the US continued to see moderate outflows as well with a $1.3bn (-0.4%) redemption last week. Because the majority of these funds still invest in USD debt, these outflows amplify the selling pressure in the secondary USD HY market. January’s 34bps spread tightening and +0.64% total return is even more impressive when viewed in this context.

 - source Bank of America Merrill Lynch

Could the current trend in continuous outflows start in earnest biting credit spreads in the High Yield space? This is an important question from an allocation perspective for the yield hungry crowd. On that subject we read with interest Barclays take in their US High Yield note from the 2nd of February entitled "Stumble and a Trip over Treasuries":

"High yield spreads have continued to rally through their 2014 tights even in the face of a pickup in supply and persistent outflows, with the 24 bp spread tightening year-to-date through Wednesday almost offsetting the 31 bp increase in 5y rates in January. As discussed in Fuller Cushions In Lower Quality, the ability of spreads to absorb rates is diminished when spreads have been at similar levels. And while markets have largely shrugged off weakening technicals, we take a more cautious near-term and tactical view considering tight valuations and the potential for further outflows driven by large adverse rate moves.

As noted in Temporary Relief from Rate Fears, outflows alone are typically not a catalyst for prolonged spread widening and particular pressure on returns. The recent experience has followed that playbook, and cumulative outflows of $23 bn over the past 12 months have done little to derail cumulative total return of 6.6% over the same period of generally stable or improving macro trends. But looking further back, episodes such as the "taper tantrum" suggest that the opposite can occur. Over the one-month period following the 34bp flare-up in 5y rates in May 2013, high yield mutual funds endured outflows of more than $8.5 bn and the High Yield Index widened by more than 50bp. We do not anticipate a similar response, but believe that this could be indicative of the direction of fund flows, if not the magnitude.

To examine the relationship between rate moves and flows in and out of high yield mutual funds more closely, we rank monthly moves in 5y rates by decile in rate rising environments and look at the average mutual fund flow as a percent of total AUM the following month. When considering all spread environments. Figure 1 shows that outflows tend not to materialize even when rates increase by more than 30bp, as they have recently.

But restricting our analysis to months when the high yield market has started tighter than 450bp (approximately the long-term average, excluding the financial crisis), shows a clearer relationship: the sharper the rate move, the larger the outflow (Figure 2).

The last two deciles, in particular, seem relevant today given a similar-sized increase in Treasury yields over the past several weeks.

The recent divergence between flows and returns, particularly stark in 2017 (Figure 3), warrants further analysis of whether rate moves and associated outflows can be a drag on total returns.

We thus tweak the analysis above to examine how High Yield Index returns vary with changes in rate movements in both normal and tight spreads environments. Two things stand out:

• When considering the full history of spread environments, increases in Treasury yields typically do not weigh on returns. Figure 4 shows no clear relationship between changes in 5y Treasury yields and one-month-forward total returns, largely in keeping with the results of Figure 1, which shows the ensuing fund flows.

• But in tight spread environments, adverse rate movements can affect the near-term performance of the High Yield Index. The inflection point beyond which returns are dragged down by rate movements appears to be around 23bp. Past that threshold, rate moves have, on average tended to produce negative returns for high yield credit in the next month (Figure 5).

The findings in Figure 5, particularly the negative high yield total returns after month of large moves in Treasury yields in tight spread environments, are logical and intuitive. Carry in tighter spread environments is not able to offset the drag on total returns produced by large increases in base yields. But we think this is amplified by our findings that escalation in Treasury yields similar to those seen year-to-date have historically preceded larger-than-average outflows from high yield mutual funds the following month. Finally last week, in Vol Hunting Heading into Earnings, we noted that there is historical evidence to support a pause or outright reversal in spreads during earnings seasons in similar tight spread environments. All of these data suggest near-term caution toward the high yield asset class" - source Barclays.

As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. Pretty simple. Therefore we are not surprised by Barclays take on the feedback loop we can have between higher rates and outflows for US High Yields in a very tight spread environment. Things can indeed turn "South" rapidly, regardless of how feeble the retail investment crowd is in the ETF sector.

Given the change in the narrative of the Fed and it's continuing hiking path and the fear of rising inflation expectations, one could rightly ask given recent market gyrations if the shot across the bows mark the end of financial repression and indicate trouble ahead for the Risk Parity investing crowd. On this subject we read with interest Deutsche Bank FX Special report from the 4th of February entitled "Risk Parity, FX and the end of financial repression:

"The charts below show that consecutive weeks of higher US bond yields and lower equity prices, have become progressively less common since the 1980s/1990s, and especially since the 2008 financial crisis. Three weeks, of equities down,10y yields up, has not happened for more than a decade. The bad news, is the markets may be contending with a shift in two big macro factors that point to a change in the post-2008 world: i) reduced financial repression, and, ii) some inflation creep

A look through history does show that in an environment where US 10y yields go up and equities go down, the USD tends to go up sharply versus the AUD and the JPY. The JPY loses out more from higher US yields than it gains protection from the retreat in risk appetite. In a higher 10y yield, lower equities environ, the USD has historically traded near flat versus the EUR, but in aggregate this still leaves the USD up moderately on a TWI basis. With bond and equity prices tumbling in the last week,the FX markets price action did conform remarkably closely to how the USD has traded in tough risk parity environments of the past, going back over the last 30 years.

Bond and equity prices falling sharply on the week may feel like an unusual environment, because in the last decade, it has become unusual. However, especially as we go back to the 1980s and 1990s it was a more frequent occurrence to see the following causal chain develop: Equities go up, supporting growth with a lag, pushing bond yields up, to the point where higher bond yields eventually pull equities down. In this way the equity - bond causality and correlation shifts, from a positive correlation where equities drive up yields, to a negative correlation as bond yields take the causal lead in pushing equities down.

From a macro perspective what is intriguing about this dynamic is two old school factors could be back in play: i) At least in the US there is a confluence of inflationary factors - lagged demand, tight labor markets, the tax reforms impact on wages/bonuses and growth, higher oil prices, latent protectionism, and the weak USD. All these factors are apt to have a cumulative effect, chipping away at global disinflation and inflation inertia. ii) the Fed and other Central Bank's balance sheet adjustments, may signal the end of financial repression, and this repression likely helped risk parity trades.  Risky assets are understandably worried because these are indeed important changes.

Now for the good news. Figure 1 below shows the number of weeks in each year where the S&P went up and the 10y yield went up. This was a common event in a high inflation era, but dwindled in the noughties, and especially after 2008 when the Central Banks went out of their way to support asset prices by supporting bonds. The good news that Figure 1 reveals, is it becomes very rare for the S&P and Bond yields to go up two and especially 3 or 4 consecutive weeks on the trot. Three weeks, of equities down 10y yields up has not happened for more than a decade.

Consecutive week after week of both bond and equity price declines is unusual. This is likely to prove true in current circumstances, where the US bond market is such a stand-out relative to other G10 bond markets. US 10y yields will likely not easily soar much above 3% without finding some real support, most obviously near the 3.03% January 2014 yield peak. In addition, were bond yields to keep on going higher, it would do enough damage to stocks to start hurting growth expectations, in turn supporting bonds. Bond bears would in this way create the source of their own demise, which is not an unusual self correcting mechanism.

In that sense we do not want to exaggerate the prospect of weeks like we have gone through that threaten risk parity trades consistently. At the same time, if inflation pressures and quantitative tightening are not about to change, then the weeks where both equities and bonds sell-off will become a good deal more frequent than we have seen since the Great Financial crisis.

So what does this all mean for currencies?

The Tables below shows how currencies have traded under different bond (10y yield) and equity (S&P) scenarios.

We first demarcate each week as falling into one of 4 scenarios: S&P up, 10y yield up; S&P up 10y yield down; S&P down and 10y yield down, and S&P down, 10y yields down. We then looked at how currencies traded, taking medians and averages of the weekly performances for ach scenario.

The table below shows the following:

i) The percent of time when S&P is down and 10y yields are up is roughly 1 in 6 trading weeks, so not all that unusual, but certainly less common than the other scenarios.

ii) In the environment where 10y yields go up and equities go down, the USD tends to go up sharply versus the AUD at least in the past decade. The USD also goes up substantially versus the JPY. The USD is mixed to near flat versus the EUR (or before the EUR the DEM). This leaves the USD up moderately on a Trade weighted basis. Since 1999, the USD also appreciates (somewhat less than we might expect) versus EM carry - using the Bloomberg EM-8 carry index of cumulative total returns. The USD's positive response versus EM looks much more substantial when using average weekly gains as distinct from median weekly gains. This suggests that every now and then there are some very large negative EM moves, when US bond prices and stock prices go down, which is not a huge surprise.

To summarize, past history does tend to support the thesis that when it feels like there is nowhere to hide between poor simultaneous trading conditions in the equity and fixed income markets, the USD and more recently the EUR have been the currencies to shelter in.

With bond and equity prices tumbling in the last week, the FX markets price action conformed remarkably closely to how the USD and other currencies have traded in tough risk parity environments of the past 30 years." - source Deutsche Bank

As a rule of thumb, positive correlation between growth assets is most notable when investors are most concerned about risk as we indicated in our May 2012 conversation "Risk-Off Correlations - When Opposites attract". Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet. As posited above rising positive correlation between macro variables in recent months should always be seen as instability brewing which increases the probability of a pull-back.

From a credit perspective, another shot across the bows is also coming from the Citi Economic Surprise Index (CESI) which could potentially indicate that economic fundamentals are trading ahead of themselves and could portend some credit spreads widening in the near future. On this subject we read Bank of America Merrill Lynch's take from their Securitization Products Strategy Weekly note from the 2nd of February:

"As nominal Treasury yields and breakeven inflation rates moved steadily higher over the past month (Chart 69), several market indicators we analyze suggest that the wind in the market’s sails may be fading.

As a result, the massive stock rally and price momentum experienced since the beginning of the year were thwarted this week as markets endured a spike in the VIX index and the worst weekly declines since 2016 (Chart 70).

Furthermore, the Citi Economic Surprise Index (CESI), which has previously been a decent indicator of the future direction credit spreads may take, continued to fall this week (Chart 71) while liquidity risk and financial stress, as measured by BofAML GFSI™ liquidity risk and financial stress indicators, rose (Chart 72).

Admittedly while the falling CESI could be somewhat seasonal in nature, the decline may also reflect the notion that expectations regarding economic fundamentals may have gotten ahead of actual fundamentals.

Historically, we’ve noticed a reasonably strong relationship between the inverse of Citigroup Economic Surprise Index and both the IG CDX (Chart 74) and HY CDX (Chart 75) indices: credit spreads tend to tighten as the CESI rises and vice versa.

With the CESI currently showing few, if any, indications that it may rebound over the near term, Treasury yields gapping higher and equity markets selling off, it is likely that credit spreads from other sectors will remain under pressure over the near term, which sets the stage for softer CMBS spreads as well." - source Bank of America Merrill Lynch

Is this time different when it comes to the relationship with rising yields, outflows and weakening CESI in recent weeks? We do not think so. 

At some point there is a potential strong risk reversal in US long bonds we think and that would put us back into the "deflationista" camp. For now the "inflationista" camp are having a field day but, as we pointed out be careful of what you wish for when it comes to inflation. Global rise in inflation expectations would indeed intensify the pressure on risky assets as we pointed out in our conversation "Who's Afraid of the Big Bad Wolf?". Remember what our friends say above according to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…You have been warned, again...

Back in December in our conversation "Rician fading" we  reminded ourselves about the Laffer Curve which used to mean the following: "Too Much Tax Kills the Tax". With the upcoming Tax deals mostly benefiting the 1%, we mused that "Too Much Wealth Effects Kills the Wealth". In our final chart below we tackle again the "Wealth" defect.

• Final charts - The "Wealth" defect

The wealth effect is the premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. According to the Fed and other central bankers following the same policies, the wealth effect should have enabled a repair of the balance sheet of households deeply impacted by the Great Financial Crisis (GFC). On top of the Wealth Effect thanks to ZIRP, NIRP and various QE iterations, the US has just implemented at the late stage of the credit cycle some "Trickle-down economics", also referred to as trickle-down theory. This economic theory advocates reducing taxes on businesses and the wealthy in society as a means to stimulate business investment in the short term and benefit society at large in the long term. However has shown in our final charts below from Wells Fargo Economics Group note from the 2nd of February 2018 entitled "The Rich Get Richer - Ownership Drives Net Worth", only the wealthiest American families have fully recovered from the financial crisis:

"Diverging Trends in Median and Mean Net Worth

Key indicators associated with household wealth might give the impression that balance sheets should be in much better shape than they actually are. Home prices, for example, are at or near their pre-recession peak in many markets. Stock prices are more than 80 percent above their prerecession peak. Yet, in inflation-adjusted terms, median household net worth is still about 30 percent below where it was back in 2007 (Figure 1).

Only the wealthiest American families have fully recovered from the financial crisis (Figure 2).

 - source Federal Reserve Board and Wells Fargo Securities

The outsized wealth gains recorded in recent years by high-net-worth families are reflected in the disparity between median and mean net worth, which have de-coupled since 2007. This is because “mean” net worth is calculated by taking the average net worth of all families, and is pulled up by very high values at the top of the distribution. Meanwhile, “median” net worth is that of the middle family (50th percentile), and is therefore not lifted by extreme values at the top of the net worth distribution, or impacted by changes isolated at either end of the distribution.

What Figure 1 shows is that before the financial crisis, net worth for the median American family was growing on a similar trend as net worth across all families. However, after 2007, high-net-worth families experienced much larger gains (or smaller declines) in net worth than middle wealth families. As a result, the mean – pulled up by wealthy families - did not show the same precipitous decline as median net worth post-financial crisis so the data does not track net worth growth of individual families. Rather, data from the SCF reflects how the distribution debt and asset ownership changes across society over time.

Fewer and Smaller Mortgages Reduces Debt

Changes in net worth occur because of growth (or decline) in debt and asset values. In the years after the Great Recession, middle- and high-net-worth families have reduced the quantity of debt on their balance sheets, contributing positively to net worth (Figure 3).

  - source Federal Reserve Board and Wells Fargo Securities

The median family with debt owed $59,800 in 2016, which is $18,200 less than in 2007 in real dollars. Mean family debt has similarly declined, down $22,500 since 2007 to $123,400.

Residential debt is the most commonly-owned type of debt after credit card debt, and makes up the largest share of debt that families hold. Therefore, trends in mortgage debt have a large influence on trends in overall family debt. A main contributor to debt reduction since the Great Recession is fewer, smaller mortgages. For mortgage owners, median and mean mortgage debt have both declined by about $13,500 since 2007. In addition, fewer families have mortgages: 40 percent of families in 2016, compared to 46.3 percent in 2007.

Lower debt among families is not just as a result of paying down mortgage balances, but also because fewer families are participating in the real estate market. The homeownership rate has declined from 69 percent in 2007 to less than 64 percent today. Whether by choice (preference for renting) or circumstance (tighter regulatory standards), fewer Americans have a piece of the American Dream in this expansion.

It’s Not What You Owe, it’s What You Own

The source of the divergence in median and mean net worth is asset values more than quantity of debt. Whereas the median family which holds assets owned about $256,500 worth in 2007 (in 2016 dollars), this has since dropped to $189,900 (Figure 4).

  - source Federal Reserve Board and Wells Fargo Securities

In contrast, the mean family with assets now values these at about $792,000, up from $775,900 just before the financial crisis.

This story has to do with the mix of assets that families of different wealth levels own, and trends in ownership rates. When looking at homeownership by net worth percentile, we see that the decline in homeownership is concentrated at lower percentiles of wealth. From 2007-2016, the share of families in the second quartile of net worth (25th-49th percentile) owning homes declined 14.1 percentage points to 58.1 percent, compared to a 2.2 percentage point decline in homeownership to 94.6 percent for families in the top decile of wealth (Figure 5).

  - source Federal Reserve Board and Wells Fargo Securities

The share of middle-wealth families owning other types of assets has also fallen at a faster rate versus high-net-worth families. Fewer families in the second quartile of the net worth distribution are owning vehicles (-1.5 points), retirement accounts (-5.5 points) and stocks (-4.3 points). Meanwhile, families in the top decile of net worth own stocks at a slightly lower rate (-1.8 points), but more own retirement accounts (+3.8 points) and about the same percentage own vehicles.

Lower asset ownership subtracts from net worth, since the value of asset holdings declines. Even for middle-net-worth families who own assets, they have not added as much to their holdings since 2007. Families in the second quartile saw retirement account and stock median values decline 13.8 percent and 5.7 percent, respectively. For families in the top decile, retirement accounts gained 71.3 percent and stocks 38.1 percent over the same period. This has exaggerated the pre-existing disparity in the value of asset holdings between middle and high-net-worth families (Figure 6).

 - source Federal Reserve Board and Wells Fargo Securities

The CoreLogic home price index has gained about 45 percent since its trough in February 2012. Meanwhile, the S&P 500 is up about 250 percent since its 2009 recession-low. The combination of lower asset ownership rates and smaller holdings for middle-wealth families, therefore, is a major reason that explains why mean family net worth has recovered since the Great Recession while median family net worth has languished." - source Wells Fargo

Some would argue that "Capitalism" has been seeding the seeds of its own destruction. As we posited in the past, bear markets for US equities generally coincide with a significant tick up in core inflation as we indicated again in our recent conversation "Bracket creep" until recently the US economy  has been plagued by "fixed income" (lack of wage growth) and "floating expenses" (healthcare and rents):

"Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation. Given most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple" - Macronomics, January 2018

After all it seems that the "Wealth defect" could be leading in the end to trickle-down "inflation" but the wrong one, but, we digress again... 

"The best way to destroy the capitalist system is to debauch the currency." - Vladimir Lenin

Stay tuned ! 

Equities, playing defense - Consumer staples, an embedded free "partial crash" put option

"Defense is a definite part of the game, and a great part of defense is learning to play it without fouling." - John Wooden, American coach

In continuation to previous conversations discussing the relationship between equity versus credit we would like to point out the downward protection offered by Consumer Staples and its recent relationship with High Yield since the financial crisis of 2008/2009. We will also look at the "greatest anomaly" namely that you get superior long term returns from low volatility equities.

As indicated by a very interesting note from Societe Generale from the 26th of March from their Global Quantitative Research team entitled - Consumer Staples outperformance solely attributable to market crash protection where they indicated the following relationship with the high yield bond market:

"Over recent years, the Global Consumer Staple sector has performed more in line with the high yield bond market than the broader equity market – or indeed, the MSCI high dividend yield index. This market-beating performance has been attributed to the clamor for quality yield but we’re not convinced. Here we show that the outperformance was wholly driven, not by yield, but the ability to limit losses during periods of acute market weakness. Essentially, fund managers are not seeking yield but buying downside protection, and in a world where market shocks are more common, the resulting premium is perfectly understandable." - source Societe Generale

Consumer Staples, or how to play defense when capital preservation dominates performance:

"The chart below plots the performance of the Global Consumer Staples sector versus high yield bonds, high yield equity and the overall global equity market. As the chart shows, in recent years, whilst ‘high dividend yield’ has largely tracked the equity market, the Consumer Staples sector has more closely mirrored the high yield bond market. Not only are total returns similar, but drawdown (peak to trough losses) have also been around 35%." - source Societe Generale

"From the chart above it seems that the outperformance of high yield bonds and the Consumer Staples sector has been fairly consistent, but the relative performance versus MSCI World reveals that the bulk of outperformance came during the financial crisis of 2008/09 and the Eurozone crisis in the summer of 2011." -  source Societe Generale

"Capital preservation is a concept that many investors understand but perhaps underestimate. No doubt this is because major market declines tend to happen suddenly and on a relatively infrequent basis. This is also why market bears – as we know from experience – tend to look completely stupid most of the time. To demonstrate the importance of loss avoidance, we have taken the often quoted Consumer Staples sector as our example and we aim to demonstrate that the premium afforded to this sector and its outperformance in recent years is courtesy of downside protection." - source Societe Generale

On another note, Gary Shilling in a Bloomberg column on the 30th of January entitled - Where to Invest While Markets Remain "Risk On" also seems to favor Consumer Staples as part of an overall investment strategy:

"Consumer Staples and Food:

Items such as laundry detergent, bread and toothpaste are essentials that are purchased in good times and bad. Their producers’ equities will remain attractive. The Standard &Poor’s Consumer Staples Sector Index was up 10.8 percent last year, after a 14 percent gain in 2011. Among retailers of consumer staples, the winners may continue to be discounters, such as Family Dollar Stores Inc. U.S. used-merchandise stores have been thriving. Producers of national brands will need to continue to adapt to weak consumer incomes and high unemployment by emphasizing cheaper “value” products."

But moving back to the downside protection offered by Consumer Staples, Societe General offers some an interesting analysis on the downside premium offered by this sector:

"Firstly, we devise a strategy that invests mainly in Consumer Staples but we switch into the equity market rather than the staying in the sector during periods of major market declines. By doing this we effectively remove the drawdown protection from the sector by being totally invested in equities instead of lower-beta Consumer Staples during market pullbacks. 

So, with perfect foresight, we identify the months when the MSCI World index lost more than 3%. Then, rather than stay invested in Consumer Staples (as you should), we invested (mistakenly) in the equity market instead. The purpose here is to understand just how important capital preservation is in driving overall returns from the Consumer Staples sector versus the market by replacing the best months of relative performance with the market return. By investing in the market, and not the sector, during those periods when the market was down 3% or more effectively kills the outperformance of the sector, to the extent that the sector goes from outperforming by nearly 50% to underperforming by 20%. This in part starts to demonstrate just how important the downside protection is in driving the performance of this sector.

If we repeat the exercise but this time for a threshold of -5% or more (which happened 12% of the time), we find that the sector performs in-line with the market. This suggests to us that the value of the put option offered by the Consumer Staples sector protects investors from monthly declines of 5% or more i.e. you can generate market performance and be insulated to a degree from major market shocks." - source Societe Generale

"Let’s explain things a little differently. Imagine a strategy where one invested in the market most of the time but (with perfect foresight) switched into the Consumer Staples sector during months when the market fell by 3% or more. By comparing this strategy to the performance of Consumer Staples sector we can measure the protection being offered and, as we show below, see that this strategy outperforms the Consumer Staples sector, implying that the better performance of the sector is not sufficient to compensate the investor when markets decline by 3% or more. But what happens if we switch to investing in the sector during months when the market fell by 5% or more?

While our strategy invests in the market 88% of the time and in the sector just 12% of the time, its performance almost perfectly matches the overall performance of the Consumer Staples sector. Hence our assertion that the sector is primarily a market index with a put option attached, much in the same way we describe another quality measures such as Merton’s balance sheet model and Piotroski’s F-score." 

Societe Generale concluded their note with the following important point relating to the limitation of the protection offered by Consumer Staples:

"Of course the Consumer Staples sector does not fully protect the investor as it too can fall, but historically by only 60% of the market fall. Valuing our put option is difficult. But with the incidence of months when the market fell by 5% or more being twice as common in the last 15 years than in the previous 25 (see below), this put option has become more important to investors. As we have stated on numerous occasions, understanding drawdown risk and capital preservation qualities is paramount to understanding what an asset is worth. With the events in Cyprus still ringing in our ears, that has never been more relevant than today." - source Societe Generale

The downward protection from Consumer Staples can be illustrated from the following Bloomberg graph highlighting the performance of Consumer Staples versus Consumer Discretionary and Financials since October 2007 until October 2012:

Another way in protecting a portfolio is investing on ETFs such as the PowerShares S&P Low Volatility Portfolio for protection from stock-market swings as indicated by Charles Stein in his Bloomberg article from the 20th of March - ETF Beating Markets With Gains Less Price Swings:

"Investors who bought PowerShares S&P 500 Low Volatility Portfolio for protection from stock-
market swings when it debuted almost two years ago got an unexpected bonus: They also made more money.
The $4.1 billion exchange-traded fund, which owns the 100 stocks in the Standard & Poor’s 500 Index with the lowest volatility, gained 30 percent since its inception on May 5, 2011, compared with 21 percent for the benchmark U.S. index. The ETF, the largest of its kind, achieved that performance with about 70 percent of the volatility in the index, giving it a risk-adjusted return double that of the market, according to the BLOOMBERG RISKLESS RETURN RANKING." - source Bloomberg

Of course, no real surprise looking at the composition of the index detailed in the article and the "defensive theme" of its components:

"In the low-volatility index, utilities represented 31 percent of the portfolio, compared with 3.4 percent in the regular U.S. benchmark, and consumer staples accounted for 24 percent, versus the index’s 11 percent at the end of February, according data from Standard & Poor’s. Information technology, which represents 18 percent of the S&P 500, made up 3.6 percent of the low-volatility portfolio.
Among the biggest individual holdings in the PowerShares ETF are Johnson & Johnson and PepsiCo Inc., the two stocks in the S&P 500 with the lowest volatility over the past year --10.1 and 10.4, respectively. Johnson & Johnson, based in New Brunswick, New Jersey, advanced 21 percent in the 12 months ended March 15, and Purchase, New York-based PepsiCo climbed 18 percent." - source Bloomberg.

In terms of top contributors to the performance, in continuation to our "defensive them" the article indicated Consumer Staples as the top performers:

"The biggest contributor to the ETF’s performance over the past year include H.J. Heinz Co., the Pittsburgh-based ketchup maker being acquired by Warren Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc., portfolio data compiled by Bloomberg show. Hershey Co., the Hershey, Pennsylvania-based candy company, was the second-biggest." - source Bloomberg

We indicated early in our conversation we would look at the "greatest anomaly" namely that low volatility stocks have provided the best long-term returns. In addition to Societe Generale's point on the defensive features of low-volatility stocks such as Consumer Staples, they also provide the best returns as indicated in the same Bloomberg article from Charles Stein:

“The long-term outperformance of low-risk portfolios is perhaps the greatest anomaly in finance,” Harvard Business School Professor Malcolm Baker wrote in a 2011 paper in Financial Analysts Journal.

When S&P designed the low-volatility product, it traced the history of the index back to 1990 in a process known as backtesting. The numbers showed that over three, five years and 10 years, the low-volatility index had a higher total return than the S&P 500.

Harvard’s Baker said market data going back to the 1930s show that low-volatility stocks have delivered about the same returns as market indexes, a result that contradicts the notion that higher risks translate to higher rewards. “In this case you are taking less risk, but not giving up any return,” he said in a telephone interview.

Investor Behavior

Other studies have come to similar conclusions, according to Joel Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc., who said finance scholars have a hard time explaining the mismatch. Most theories attempting to explain it revolve around investor behavior.

Because people are overly smitten with fast-growing, glamorous companies, they bid up the prices of those stocks to the point where future returns suffer, said Dickson.

Dickson offers a caveat. When stocks soar as they did in the 1990s, low-volatility holdings can underperform for long stretches, said Dickson, a senior investment strategist at Valley Forge, Pennsylvania-based Vanguard Group Inc. “As an investor you have to be willing to stomach periods

when this strategy gets killed,” Dickson said in a telephone interview.

In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index." - source Bloomberg

We therefore disagree with Gary Shilling, Consumer Staples are not purely a "Risk-On" strategy given that as indicated by Bloomberg:

"In the nine years ended Dec 31, 1999, a period in which stocks gained 21 percent a year, the S&P 500 Index returned more than twice as much as its low-volatility counterpart, according to data compiled by Bloomberg. It also outperformed after accounting for price swings, with a risk-adjusted return of 32 percent, compared with 20 percent for the low-volatility index." - source Bloomberg

But, Consumer Staples are mostly a defensive play that can outperform during phases of "Risk-Off" which we have been experiencing on numerous occasions since the financial crisis of 2008:

"The low-volatility index did best in times when stocks fell, such as 2000 to 2002, and in 2008, according to S&P data. In 2008 the low-volatility index fell 21 percent compared with 37 percent for the S&P 500." - source Bloomberg.

On a final note, in relation to the differences between equity and as posited by our good friend Paul Buigues, Head of Research at Rcube Global Macro Research in his post "Long-Term Corporate Credit Returns":

"Equity is an infinite claim on the free cash flows generated by a company. Due to the inherent uncertainty of future cash flows, relying on a pure valuation framework to predict equity returns is often a disappointing experience, for both specific companies and equity as an asset class.

Corporate debt, on the other hand, is generally a finite claim on a predetermined stream of cash flows (coupons + principal repayment)."

Corporate credit is a much simpler bet than equity, especially for investors that hold credit instruments until maturity. For instance in High Yield as indicated by our friend Paul "initial spreads explain nearly half of 5yr forward returns" (even for a rolling investor (whose returns are also driven by mark-to-market spread moves). 

When it comes to yield the PowerShares ETF has a dividend yield of 2.78 percent compared to 2.13 for the S&P 500 Index, according to data compiled by Bloomberg, so could it be that after all Consumer Staples in  the equity space are a much more simpler bet, in similar fashion to corporate credit? One has to wonder...

"Right is its own defense." - Bertolt Brecht

Stay tuned!