Guest post - Is Risk Parity a Scam - Rcube Global Macro Research

"We have a natural right to make use of our pens as of our tongue, at our peril, risk and hazard." - Voltaire 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Paul Buigues looks at Risk Parity strategies:

(for PDF please use the following link: http://www.rcube.com/docs/Rcube_Is_Risk_Parity_a_Scam.pdf)

Risk parity strategies experienced large drawdowns between early May and late June due to a combination of rising government yields and falling equities.

Note: The original and largest fund in the sector (Bridgewater All Weather Fund) does not publish daily NAVs.

This rather significant correction raised quite a few eyebrows, particularly because risk parity strategies are often marketed as being able to withstand a wide range of economic environments (and, unlike 2008, today’s environment is rather benign).

Although it would be preposterous to disparage a strategy based on two months of negative returns, this drawback gave us the impetus to express our thoughts on risk parity as an investment strategy, as it emerged from relative obscurity just a few years ago, only recently becoming fairly popular among investors.

Like other passive asset allocation strategies,1 the basic premise of risk parity is that asset returns are unpredictable, at least in the short] and medium]term. Consequently, investors should only attempt to capture risk premia, without wasting their time and energy trying to forecast the behavior of specific asset classes.

According to the Modern Portfolio Theory (which is, itself, based on a dozen theoretical assumptions), the only rational choice for an investor is consequently to own the gmarket portfolioh which contains every asset available in the market, weighed according to its relative size. Because this is difficult to implement in practice, investors often settle for a (generally more granular) version of the 60/40 allocation between equity and fixed income.

Risk parity is a different viewpoint on how not to exert judgment on any asset class. According to risk

parity proponents, investors should try to own all major investable asset classes on an equal risk basis.

Supposedly, this results in portfolios that have better risk/reward characteristics than traditional asset allocations. Moreover, as mentioned above, some argue that risk parity portfolios can generate quasi-absolute performances, even in the face of stormy markets.

Before going any further, it is worth stating that implementing a portfolio that contains all assets on

an equal-risk basis is even more challenging to implement than implementing the "market portfolio".

This explains the existence of many different variants of risk parity.2

Recap: Portfolios that express a neutral view on future asset class returns

After selecting a specific variant of risk parity, many implementation choices need to be made:

‐ What universe of assets should be used, and how should they be regrouped them in asset classes?

‐ Should asset class correlations be taken into account? And if so, how?

- How should we define risk? In our understanding, most risk parity implementations use volatility,

which obviously exists in many different varieties (historical, implied, predicted, GARCH, etc.) and

calculation horizons.

- What leverage should be applied to the portfolio for it to reach an acceptable rate of return? (Risk

parity generally involves leverage.)

- What frequency should be used for portfolio rebalancing and volatility calibration?

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1 Although risk parity strategies have to be managed actively (if only to equalize risk levels on a regular basis), we consider them to be passive, in the sense that they are not based on trying to forecast future asset returns.

2 Here are just a few implementations of risk parity: the “All weather” portfolio, classical risk parity, cluster risk parity, risk factor parity, and equal risk contribution.

To our understanding, the “All weather” strategy is not risk parity in the strict sense. From the way it has been described in various papers, it basically consists in choosing a set of asset classes, and in leveraging each of them to obtain a common expected return (generally the expected return of equities). In that sense, this strategy should be called return parity, rather than risk parity. Unless we expect all asset classes to have the same Sharpe ratio, these two approaches are not equivalent.

Due to this large number of degrees of freedom and parameters, this paper will present risk parity from a generic viewpoint. It will contain case studies and thought experiments rather than backtests (as we will see, backtests are generally biased towards risk parity strategies).

Although the term “risk parity” was only introduced in 2005, we can trace the origins of the concept

to a strategy that Ray Dalio (3) started using in 1996 to manage his family trust. Despite Bridgewater’s success in generating sizeable alpha for their clients, Dalio wanted to create an investment process that would not depend on his own ability to manage funds or to select managers (as he wouldn’t be able to do so after his death).

The strategy (named the “All Weather portfolio”) also had to deliver returns, regardless of economic

conditions. Dalio therefore concluded that the portfolio should maintain 25% of the portfolio’s risk in

each of the four following quadrants:

This is clearly an excessively simplified portrayal of a strategy that now has $70Bn under management and that has generated an annualized performance of around 8.5% with a volatility of around 10% since 1996, inspiring many fund managers and institutional investors to run the same type of strategies in-house.

However, despite its commercial and financial success, many observers consider risk parity to be an

investment scam. Finding a strategy that might dominate the classical 60/40 portfolio is one thing. Pretending that this strategy is able to produce stable returns (without attempting to predict those returns) sounds a lot like a "get rich steadily and without effort" scheme.

Even though wefre not into passive asset allocation strategies (otherwise, we would look for another

line of work), we will try to contribute to the debate. We will organize our thoughts by looking at

three intertwined dimensions of risk parity: diversification, returns, and risk. In each section, we will

express our opinion on the conceptual merits of risk parity, as well as its prospects in the current

environment.

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(3) Ray Dalio is Bridgewater’s founder and one of risk parity’s pioneers. Despite the criticism against risk parity expressed in this paper, Dalio is at the very top of our pantheon of financial thinkers.

1. Diversification

From a passive asset allocation standpoint, it is hard to argue against diversification, which

constitutes the core of risk parityfs philosophy.

The idea of spreading risk among different asset classes obviously precedes risk parity by a few millennia, as we can find references to it in the Talmud ("One's assets should be divided into thirds: 1/3rd in land, 1/3rd in business, 1/3rd in gold") or in the Ecclesiast ("Divide your investments among many places, for you do not know what risks might lie ahead").

In the early 1980s, Harry Browne introduced the gpermanent portfolioh, an investment strategy whose aim was to withstand all sorts of economic environments, and which was originally composed of an equally weighted portfolio of four asset classes: 25% US stocks, 25% long-term bonds, 25% cash, and 25% precious metals.

However, it is worth noting that these simple equal]weight approaches only aim at minimizing the risk of ruin from a personal wealth standpoint, which is not the modern view of how portfolios should be managed (i.e., maximizing investment returns for a given level of risk).

In terms of diversification, the major innovation of risk parity over these early approaches resides in

equally weighting risks, instead of allocations.

In that respect, risk parity proponents are indisputably right when they state that traditional 60/40 asset allocations are not truly diversified, as they have had a correlation of 0.90 with equities over the last 40 years.

That being said, we believe that placing diversification above everything else can lead to unpleasant consequences. The main advantage of a passive gmarket portfolioh approach is that, by definition, it does not disturb the market's equilibrium, as every asset class is weighted according to its relative importance in the market. On the opposite side, once it becomes popular, any other passive investment process that significantly deviates from market weights can wreak havoc in market valuations, precisely because passive investment processes entail not caring about valuations.

For example, letfs take a small exotic asset class (public Timber REITS, for instance), which would display nice diversification properties in the eyes of many different diversification]minded managers. Although each individual manager might decide not to own more than 1% of the total float, their combined buying power could very well provoke a bubble in the asset class.

A real-life example of the damage that can be caused by a blind quest for diversification can be found

in the way in which CDOs used to be managed before the credit crisis. In order to increase their contractual Moody's "diversity score", CDO managers were forced to diversify their exposures in terms of industries. As a consequence, some industries that had little outstanding debt became heavily sought after and, therefore, completely mispriced. In the end, a supposedly superior diversification did not help CDO managers, as correlations converged towards 1.00 during the 2008 credit crunch.

To a certain extent, the appeal of diversification might also explain investorsf willingness to buy TIPS

at negative yields (down to around -1% for the 10 years recently). While being a relatively small part of government debt (around 10%), TIPS' characteristics make them very attractive in the eyes of

investors who value diversification far above everything else, including valuation (in this particular

case, however, the jury is still out in determining whether we’re all “turning Japanese”).

One last word about diversification: as we will see in our next section, we’re not convinced that financial markets offer a sufficient number of uncorrelated risk premia in order to be able to reach a “true” diversification.

2. Returns

2.1. Risk premia

Like any other passive asset allocation strategies, risk parity relies on the assumption that some asset

classes should structurally outperform the risk‐free rate. Although there are theoretical justifications and ample empirical evidence for some of these risk premia, their number and their magnitude is ‐ and will always be ‐ subject to intense debate.

To us, the most convincing and economically meaningful risk premium resides in equities. Because of

the high covariance of corporate asset values with the state of the economy, equities have to compensate investors for the risk they take (no one wants to lose his job and experience portfolio losses at the same time). We can obviously only make rough estimates of the forward equity risk premium (letfs settle for 5% on a global basis), but we do have little doubt about its existence.

Even if they might offer some diversification benefits from a marked]to]market perspective, we believe that many asset classes (e.g., high yield bonds, REITS, or private equity) have a risk premium that originates from the same covariance with the state of the economy. Whether they should be considered as completely separate assets classes is, therefore, debatable. In fact, this question is specifically addressed by newer risk parity implementations, such as cluster risk parity and equal risk contribution.

For some asset classes, the very existence of a positive risk premium can be questioned. In the case

of commodities, for instance, the classical justification for a risk premium (i.e., Keynesf "normal backwardation") is nowadays dubious, as an increasing number of investors have been willing to take hedgersf opposite side. Roll yields, which had been the sole source of excess returns for commodities, have been centered on zero for the last 10 years.

For other asset classes, risk premium prospects currently look rather grim, the most obvious example

being Treasuries. If we look at 10]year Treasuries, their historical long-term return over short-term

rates has been around 1.6% since 1920. Since the early 1980s however, 10-year Treasuries have produced far higher excess returns (around 5%), as 10]year yields went from 15.8% to the current 2.5%.

Although there are only a few things about which we can be certain in finance, we can safely proclaim the mathematical impossibility of getting 5% excess returns by rolling 10-year treasuries over the next 10 years.

Therefore, 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 gbig rotationh that would bring 10-year yields back to a theoretical long]term equilibrium value.

There are obviously many other sources of risk premia. However, most of them (liquidity‐based ones,

for instance) are the “bread and butter” of specialized hedge funds. Therefore, they are outside of the scope of risk parity, which is not a bad thing, as many of these arcane risk premia tend to display a very negative skewness.

Our main point is that, even if we consider a large universe of asset classes, it’s not as if there were dozens of investable and economically meaningful risk premia waiting to be harvested by passive investors. In the end, when we take into account the fact that many risk premia actually originate from the same basic sources, we might end up with just a few investable risk premia. Additionally, as more people reach for diversification, those few risk premia tend to become more correlated over time.

2.2. Leverage

One important point regarding returns resides in the fact that risk parity strategies generally involve

leverage—that is, unless the investor is satisfied with long‐term returns of 2 to 2.5% over the risk-free rate.

Risk parity practitioners generally characterize leverage as a mere “implementation tool”, and they

believe that their superior diversification outweighs the disadvantages of running a levered strategy.

Although a reasonable use of leverage might not be fatal to a portfolio, it can irremediably hurt its

returns. Indeed, as we will see in our section about risk, leverage introduces a path dependency issue.

We can very well imagine a “black swan” situation, in which a supposedly safe asset class experiences a price trajectory that forces a deleveraging of the portfolio and, therefore, wipes out a large chunk of it.

3. Risk

We believe that the subject of risk is the one wherein risk parity is the most open to criticism.

Indeed, to reach the gparityh in risk parity, one has to reduce the risk of an asset to a single number

one way or another (generally a specific variant of the assetfs volatility). Although it is not a very original point of view, we believe that the risk of an asset cannot be quantified in this simplistic way.

Despite the fact that there is a certain level of stickiness in an assetfs risk (or volatility), every now

and then, assets - even supposedly gsafeh ones - have the nasty habit of breaking the parameters of

the equations that are supposed to describe their behavior (especially if these equations do not take

into account skewness).

To illustrate this point with a little story, letfs imagine a situation that could very well have happened

during the last decade:

In the aftermath of the 2000s tech crash, John becomes yet another young unemployed electrical

engineer (as Taleb, the inventor of the Black Swan theory, likes to characterize most quants). He decides to start a new career by getting a masterfs degree in finance. Armed with his solid math skills, John quickly digests modern portfolio theory, basic statistics, and all varieties of volatility calculations. He finds a job at an institutional investor and quickly moves up the corporate ladder.

In 2006, John convinces his board to apply a risk parity strategy to manage the firm's portfolio. Because he has a fresh and open mind about finance, he decides to spice up the asset mix by adding an exposure to mortgage]backed securities in the form of newly-minted ABX indices.

Who could blame him, based on the information available in 2006?

- The total size of the US mortgage debt is huge ($13 trillion in 2006), comparable to US equities, and larger than government debt.

- ABX indices are highly diversified, as each index is based on 20 distinct RMBS transactions. Each RMBS containing a minimum of $500 million worth of homes, an ABX investor is exposed to more than 50,000 homeowners throughout the US. What can possibly go wrong with such a diversified pool of debtors?

- ABX products are rated by respectable institutions, such as Standard & Poorfs (1860) and Moody's (1909), and they offer a wide variety of risk levels (from AAA to BBB).

- The volatility of the underlying financial products that compose the index is minuscule (they always trade around par).

Even if John had opted to buy the safest AAA ABX tranches (with, consequently, a high allocation due to their glowh risk), he would have experienced heavy losses during the 2007-2008 crisis. Additionally, he would have been forced to drastically reduce his allocation to the asset class as the gtrueh risk (or volatility) of ABXs revealed itself, preventing it from benefiting from any subsequent recovery.

Consequently, given that he was running a leveraged portfolio, John would have been forced to crystallize his losses.

This story might sound far]fetched, but we could have invented a similar story about Georgios implementing a risk parity strategy for a Greek institutional investor by leveraging on domestic government debt.

Some might argue that both of these examples involve blatantly asymmetric assets, which could have

easily been filtered out (especially in retrospect) by an experienced risk parity practitioner.

However, we can also imagine a forward‐looking scenario that would involve one of the most respectable assets on earth ‐ US Treasuries ‐ as the main culprit of a risk parity carnage:

Let’s imagine that, a few years down the road, Bernanke’s successor has to manage another “great

recession”. This time, the Fed decides to go beyond QE by pegging long‐term rates at a very low level (let’s say 0.5% for the 10year).4

As the Treasury remains stuck at 0.5%, there is no more volatility on Treasuries.

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.

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 4 This solution was discussed by the Fed in late 2010, and it has already been experimented with
between 1942 and 1951.

 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fs 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 gblack swanh 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fs 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.

That being said, the idea of a passive investment strategy that would be able to withstand any kind of financial weather is not unrealistic. However, its goal should be the long]term preservation of capital and not its theoretical maximization under a theoretical risk constraint. Additionally, the strategy should make very little use of leverage, and it should not make too many assumptions on the risk of a given asset (as risk becomes an unpredictable beast every now and then). In the end, we would probably end up with something quite similar to the Talmudic portfolio (N equally-weighted assets).

We realize that, without adhering completely to risk parityfs principles, many institutional investors

are implementing it as a part of their portfolio alongside other "absolute return" strategies. This approach is clearly less dangerous than an all]in commitment to risk parity. At a portfolio level, it simply results in overweighting low]volatility assets, which is obviously far-removed from the original purpose of risk parity.that is, true diversification at a portfolio level.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury 

Stay tuned!

Credit - Alive and Kicking

"What you gonna do when things go wrong? 

What you gonna do when it all cracks up? 

What you gonna do when the Love burns down? 

What you gonna do when the flames go up? 

Who is gonna come and turn the tide? 

What's it gonna take to make a dream survive? 

Who's got the touch to calm the storm inside? 

Who's gonna save you? 

Alive and Kicking 

Stay until your love is, Alive and Kicking 

Stay until your love is, until your love is, Alive"

- Alive and Kicking - Simple Minds - 1985

Songwriters: Kerr, James / Macneil, Michael Joseph / Burchill, Charles

While enjoying the smoother driving commute to work courtesy of the summer lull, we listened to old classic 1985 "Alive and Kicking", from Scottish rock band Simple Minds, and some of the lyrics did struck a chord with the on-going central banks "kicking the can" game which has been increasing the correlation between asset classes and the levitation process. Therefore, in continuation to our previous use of musical references for our title analogy, we thought this week's title reflects our current interrogations on central banks abilities in dealing with the next burst of the asset bubble they have so aptly created thanks to their numerous and generous liquidity injections from the last couple of years.

In this week's conversation, we would like to focus our attention on the inherent "instability" which has been building up in all asset classes due to rising correlations, the consequences of negative real returns, and how to somewhat side-step negative convexity thanks to CDS. But, first, our usual market overview:

The volatility in the fixed income space has been receding during this on-going summer lull as displayed by the recent evolution of the Merrill Lynch's MOVE index falling from early May from 48 bps  towards the 75 bps level - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

A low volatility regime until May had benefitted the most carry trades such as Emerging Market Bonds as well as high carry Emerging Markets currencies. This was the direct consequence of negative interest rate of return on US Treasuries for the last couple of years due to "financial repression". Following the huge surge in volatility after the conflicting "tapering" signals sent out by the Fed that began in May, Emerging Market currencies should remain volatile and under pressure in the coming months as indicated by Bloomberg's "Chart of the Day" from the 5th of August displaying JP Morgan's Emerging Market Volatility Index:

"The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Volatility Index since Fed Chairman Ben S. Bernanke told Congress in May that policy makers may temper bond purchases that helped spur $3.9 trillion in capital flows to developing countries in the past four years. The gauge jumped to a one-year high of 11.8 percent June 21, before falling to 9.5 percent yesterday after the Fed said it will keep stimulus for now. The index’s 35 percent quarterly increase was the most since 2011.
Currencies in Brazil, India, South Africa, Turkey and Chile have fallen at least 7 percent since May 1 as higher Treasury yields lured investors away from emerging markets. Developing countries are paying for the Fed’s mixed signals and ministers from Chile to South Africa share India’s “unhappiness over the developments,” Indian Finance Minister Palaniappan Chidambaram said in an interview with the Times of India published July 31" - source Bloomberg.

A clear illustration of this surge in currency volatility can be seen in the depreciation of commodities linked currencies such as the Australian dollar and the Brazilian Real, which had been perfectly correlated since 2008 until the summer of 2011, which saw the start of some large unwinds from the Japanese levered "Uridashi" funds (also called "Double-Deckers") from their preferred speculative currency namely the Brazilian Real. Created in 2009, these levered Japanese products now account for more than 15 percent of the world’s eighth-largest mutual-fund market and funds tied to the real accounted for 46 percent of double-decker funds - graph source Bloomberg:

The Brazilian Real was one of the top "Double-Deckers" preferred currency play for its previous interesting carry. These funds represented 126 billion USD in asset in 2011:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

Following the violent surge of volatility in the fixed income space the recovery in Investment Grade credit indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG has been more muted in the US - source Bloomberg:

But as far as credit cash markets are concerned in the European space, European cash spreads are now within 5 bps of tights post the Great Financial Crisis, with the Iboxx Euro Corporate index, being one of the most used benchmark in European Investment Grade mutual funds tighter by 6 bps so far in August as indicated in a recent note by CITI "The Reluctant rally" from the 9th of August:
"In aggregate, the € iBoxx index has now taken back more than 80% of the widening in May and June – in other words, we're just 5bp from the tightest level credit has seen since 2008.
We're big advocates of leaning against the wind in the current range-bound market environment and have been suggesting taking profits at the margin where spreads have tightened the most. But we remain long. Why not be more resolute and go underweight here at these tight valuations? Sure, the European and US macro data is supportive but, after all, there's plenty of uncertainty in store in the autumn: the impact of actual Fed tapering, US debt ceiling discussions, European politics after the German elections, the German constitutional court ruling on the OMT, FTT negotiations, bank repositioning on the back of the latest Basel guidance, periphery politics, Chinese data, Middle East tensions to name a few.
Some of these issues may yet come back to haunt us but, at the moment, we struggle to see the vulnerability in the European cash credit market even at these tight levels." - source CITI

As far as credit markets are concerned, they are no doubt, "Alive and Kicking". And we agree with CITI, as the Simple Minds (like ours) song goes:
"Stay until your love is, until your love is, Alive"
So stay in credit until your love is alive, but get close to the exit as we move towards a heightened risk of a fall during the Fall (Autumn that is...).

It is a similar story for European Government Bonds yields as indicated in the below graph with German 10 year yields staying between the 1.60% / 1.70% level and French yields now around 2.26% flat from last week, with Italian and Spanish yield grinding tighter - source Bloomberg:

Moving on to the subject of rising correlations and the buildup in "instability", we agree with Martin Hutchinson's recent article "Forced Correlations" published in Asia Times:
"In 2009-10, ultra-low interest rates forced up commodity prices themselves, but since then new sources of supply have been forced onto the market, causing a reversal of the commodities bubble. In energy, fracking techniques caused a collapse of natural gas prices in 2011-12, but it's interesting to note that no such collapse has occurred in the oil market, presumably because the new supply sources are insufficient and have been offset by the artificially increased demand for automobiles in China and India especially. 

Interestingly, the rise in gold and silver prices caused by cheap money (if cash has a negative real return then gold and silver are ipso facto a good investment) has been suppressed over the last 18 months by the International Monetary Fund and the world's central banks, seeking to disguise the true effect of their monetary policies, but this effect may be wearing off. 

Finally, negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

Dollar index versus Gold - graph source Bloomberg:

While recently the dollar has been weakening so far against major currencies with a significant bounce from the Japanese yen and Australian dollar, should "risk-off" materialize during the Autumn, the dollar could significantly benefit yet again from a flight to safety.

The credit markets and equities are no exception to "rising forced correlations" as highlighted by CITI's recent note from the 9th August entitled "Forget the Great Rotation":
"Rotation – isn’t it obvious?
It's not hard to figure out why the 'Great Rotation' has been such a hot topic this year. It seems so intuitive: as yields rise over the next few years in response to a gradual economic recovery, total returns in fixed income will be weighed down, if not outright negative. The asset class that has the most to benefit from growth is equities.
For example, for the past year we have continuously highlighted the asymmetry in risk/reward between equities and credit. As illustrated in Figures 2 and 3, credit and equities have correlated closely over the last few years and almost in a constant ratio. We don't see why that wouldn't work in reverse also.

However, as credit spreads get closer and closer to the lower bound it becomes increasingly difficult for them to continue performing in the historical relationship with equities. The slight gap that appears to be opening up in both charts recently seems to bear that out.
In other words, to our minds there is an obvious long-equities-short-credit relative value trade insofar as credit has all the downside potential of equities, and much less of the upside." - source CITI

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":
"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

"What you gonna do when things go wrong? 

What you gonna do when it all cracks up? 

What you gonna do when the Love burns down? 

What you gonna do when the flames go up? 

Who is gonna come and turn the tide? 

What's it gonna take to make a dream survive? 

Who's got the touch to calm the storm inside? 

Who's gonna save you?"

- Alive and Kicking - Simple Minds - 1985

But we are not there yet...

Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

This is particularly true for callable high yield bonds such as Windstream:
"We can again use Windstream to illustrate this dynamic. Figure 5 shows the duration (OAD) and yield to worst of the WIN 7.5s of 2022 from May 10 to August 7. As the bond sold off from May 10 to June 24 (yields rose), the duration increased as well, due to the negative convexity of the bond.

The increase in duration resulted in larger losses for the bond relative to an equivalent non-callable bond and CDS. In the subsequent rally, duration declined, resulting in a smaller gain relative to a non-callable bond and CDS. The negative convexity of the bond enhanced the downside during the sell-off and limited the upside during the most recent rally. Remarkably, even though nearly three months have passed, duration remains toward the high end of the range. The holder of the bond not only suffered a mark-to-market loss, but now has to contend with a higher duration investment that continues to suffer from negative convexity." source Barclays

The illustration of the downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages as illustrated by the Total Return performance on a callable High Yield bond suffering from negative convexity versus its CDS - graph source Barclays:

"CDS has outperformed the 2022s by more than 400bp in P&L terms (Figure 8) due to the rate exposure and duration extension of the bond." - source Barclays

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

Conclusion:
With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. 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...

On a final note, counter-intuitively, rising yields should benefit US companies suffering from ZIRP due to rising  Pension Funding Gaps which have not been alleviated by a rise in the S&P 500.

As a reminder from our conversation "Cloud Nine":
"If we look at GM and FORD which went into chapter 11 due to the massive burden built due to UAW's size of "unfunded liabilities", they are still suffering from some of the largest pension obligations among US corporations. Both said this week they see a significant improvement in their pension plans liabilities because of rising interest rates used to calculate the future cost of payments. When interest rates rise, the cost of these "promissory notes" fall, which alleviates therefore these pension shortfalls. So, over the long term (we know Keynes said in the long run we are all dead...), it will enable these companies to "reallocate" more spending on their core business and less on retirees. Charles Plosser, the head of Philadelpha Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2."

We agree with Bloomberg that rising stock prices have done little to bolster the finances of corporate pension funds this year - graph source Bloomberg:

"Rising stock prices may do relatively little to bolster the finances of corporate pension funds this year, according to Tobias M. Levkovich, Citigroup Inc.’s chief U.S. equity strategist.
As the CHART OF THE DAY shows, the percentage gap between pension assets and obligations for companies in the Standard &Poor’s 500 Index widened last year, when the stock-market gauge increased 13 percent. The S&P 500 rose another 19 percent this year through yesterday.
Assets were 23 percent less than projected payouts at the end of 2012, according to data from S&P Dow Jones Indices that Levkovich presented in an Aug. 2 report. The shortfall was the biggest since at least 1991.
“Overall pension pressures have not eased” even though the S&P 500 has more than doubled since March 2009, when the current bull market began, Levkovich wrote. “The stock market is crucial to the asset side of the pension story.” Managers contributed to the wider funding gap with their reluctance to put more money into equities, the New York-based strategist wrote. Stocks amounted to 48.6 percent of assets at S&P 500 funds last year, down from 50.5 percent in 2009.
Surging obligations also played a role, according to S&P Dow Jones’s data, published last week. Projected distributions increased 38 percent, to $1.99 trillion, between 2007 and 2012. Assets rose just 2 percent, to $1.53 trillion, as the period began with the worst bear market since the Great Depression." - source Bloomberg

So much for the "Great Rotation" story. Oh well...

"At times it is folly to hasten at other times, to delay. The wise do everything in its proper time." - Ovid

Stay tuned!

Credit - Livin' On The Edge

"There's somethin' wrong with the world today
I don't know what it is
Something's wrong with our eyes

We're seeing things in a different way
And God knows it ain't His
It sure ain't no surprise

We're livin' on the edge" - Aerosmith 1993, Livin On The Edge

While we contended this week about the complacency in US stocks, when looking at the "great rotation" between institutional investors and private clients for the last five consecutive weeks as reported by Bank of America Merrill Lynch, we thought this week we would use a musical reference for a change, namely 1993 hit song by Aerosmith, which reflected at the time the sorry state of the world.

In this week's conversation, while everyone is enjoying a summer break and some much needed normalization in credit spreads, which has seen cash credit tightened overall by 5 bps this week in the European market on the Iboxx Euro Corporate index, we would like to focus our attention on the growing disconnect between asset prices and the sorry state of the real economy.

Indeed we would have to agree with our chosen title when looking how the US stock market has been defying gravity compared to the sorry state of the US labor market. There has been a growing disconnect between Wall Street and Main Street. On that note we agree with Bank of America Merrill Lynch's report from the 1st of August entitled "When Worlds Collide":

"From their 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion (in July the S&P 500 set a new intraday high). Policy, positioning and profits (in that order) best explain the seeming disconnect between Wall Street and Main Street. Wall Street and capitalists have enjoyed a boom, as the price of equities and bonds (and more recently real estate) have soared, while Main Street and the labor market have struggled" 

- source Bank of America Merrill Lynch

Yes recently we did indicate, "we're livin on the edge", when  not only looking at the rise of the S&P index (blue) versus NYSE Margin debt (red) but also at the S&P EBITDA growth (yellow) and as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

No doubt to us that the current bull market which has started in March 2009 has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks. A drop in stock outstanding accounted for 25% of 2012 earnings-per-share growth in the S&P 500. Buybacks are a global phenomenon.

Capital, courtesy of ZIRP, is not only mis-allocated but also destroyed with the "de-equitization" process in order to boost even more the "infamous" wealth effect induced rally by Mr Ben Bernanke. As far as profits are concerned, companies as sitting on record amount of cash and have generated record corporate profits as indicated by Bank of America Merrill Lynch's graph below:

"Profits: corporate austerity since the Great Financial Crisis has induced record corporate profits ($1.6 trillion – Chart 3) and record levels of corporate cash ($1.2 trillion), an asset-positive, growth-negative combo." - source Bank of America Merrill Lynch

While the latest ISM / PMI releases point to some much hoped economic recovery, the latest disappointing read of the Nonfarm payroll coming at 162 K shows how much the recovery has been tepid so far whereas equities have continued their surge undisturbed.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:

But if short term wise economic data shows some sign of stabilization, the volatility in the fixed income space is very much present as displayed by Merrill Lynch's MOVE index jumping from early May from 48 bps and surging back towards the 100 bps level - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

What we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

This latest surge in fixed income volatility has put some renewed pressure on Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG - source Bloomberg:

If the fixed income space, the goldilocks period of “low rates volatility / stable carry trade environment” of these last couple of years seems to have been seriously tested, yet there remain a big disconnect between equities and fixed income. As we posited in our conversation on the 13th of June "The end of the goldilocks period of low rates volatility / stable carry trade environment?":

"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

For now volatility indicators in both Europe (V2X) and the US (VIX) have been fairly muted. Graph source Bloomberg:

So the big question is indeed are we indeed "Livin' On The Edge"? Here is what Bank of America Merrill Lynch posited in their 1st of August note on this subject:

"United we fall, divided we rise

Secular bears of financial assets will argue, with some justification that the worlds of Wall Street & Main Street cannot diverge indefinitely. This may well be so. But in the past 5 years this view has repeatedly missed the point that a divided world of High Liquidity & Low Growth has been the foundation of a ferocious bull market in financial assets.

And of course not all asset prices have reflated as nonchalantly and aggressively as US corporate stocks and credit. Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment. A breakdown in the Continuous Commodity Index (CCI –Chart 4) below 500 in coming weeks would discourage global growth upgrades (and stymie the recent rebound in Emerging Markets). 

It is very rare to see such outperformance of defensive stocks (up 26% over the past two years) versus cyclical stocks (down 4%) in a non-recessionary world (Chart 5).

- source Bank of America Merrill Lynch

As we argued back in April this year in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option", 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 "great anomaly" has been that low volatility stocks have provided the best long-term returns.

So yes indeed in, we do live, in an ambiguous world where low volatility provides the best returns, and with a great disconnect between equities and the real economy, with fixed income and equities. We think we are "Livin' On The Edge" and as indicated by Bank of America Merrill Lynch, but, we are not too far from "The Moment of Truth":

"Perhaps the best example of this bi-polar world is the fact that the US equity market now represents almost 50% of the world’s market cap. Despite limited support from the US dollar, US equities relative to EAFE are close to relative levels not seen since the 1960s (Chart 6), as investor positioning reflects belief in ongoing US market and macro leadership.

So moment of truth for the economy will arrive in the second half of this year. If ever the US were finally to achieve “escape velocity” it must be now. Significant monetary stimulus, the end of fiscal austerity, a booming housing market, a cheap dollar, and record corporate cash balances mean the US economy should meaningfully accelerate in coming quarters. Our own Ethan Harris looks for 2.0% GDP growth in Q3, 2.5% in Q4 and 2.7% in 2014.

Our investment strategy remains predicated on that outcome. In coming quarters we expect PMI’s to accelerate, job growth and bank lending to improve, higher interest rates to coincide with higher bank stock prices, and US dollar appreciation. We favor assets (such as financial stocks) and markets (such as Europe) that have lagged in the “High Liquidity-Low Growth” world of recent years." - source Bank of America Merrill Lynch

Unfortunately we do not share Bank of America Merrill Lynch's optimism on the acceleration of USD GDP growth in the coming quarters. For us, it is still muddle-through with significant risk on the downside.

US labor growth remains very weak as indicated in the below Thomson Reuters Datastream / Fathom Consulting graph:

QE and the law of diminishing returns - US QE in practice - Payrolls and Manufacturing ISM, graph source Thomson Reuters Datastream / Fathom Consulting:

In addition to this the regular economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in June, following -4.8% in May and -7.4% in April. As a readily-available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth.

Over the past 13 years’ monthly data, there has been an 83% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months (Fig. 2). In turn, this has translated into a clear relationship between air cargo and chemical industry volume growth (Fig. 1).

- source Nomura

On a final note, if you think that stocks are "Livin' On The Edge" and that a QE tapering is around the corner, then maybe you ought to think about US Treasuries again, for a very simple reason, government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". In fact the case for treasuries is also indicated in Bloomberg's recent Chart of the Day:

Investors should buy Treasuries if they anticipate the Federal Reserve will reduce its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market.

The CHART OF THE DAY shows the benchmark 10-year yield dropped and gains in the Standard & Poor’s 500 Index slowed after the Fed ended each of the prior two rounds of quantitative easing in the past four years. The yield declined 1.26 percentage points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year. The U.S. stock gauge rose 2.4 percent, compared with a 36 percent advance during QE1.

The yield slid 1.3 percentage points between the end of the second round in June 2011 and the beginning of Operation Twist in September the same year. The S&P 500 fell 12 percent after gaining 10 percent during QE2.

“The Fed will taper QE not because the economy is booming but because the program has been creating excess liquidity, boosting risk assets too much,” said Akira Takei, the head of the international fixed-income department at Mizuho Asset Management Co., which oversees $37 billion and whose U.S. affiliate is one of 21 primary dealers that underwrite U.S. debt. “Ending QE is likely to trigger a correction in risk assets, driving bond yields down.”

Fed Chairman Ben S. Bernanke said on June 19 that the U.S. central bank may slow the third round of bond-buying, valued at $85 billion a month, later this year and end it entirely in the middle of 2014 if the economy achieves sustainable growth. Half of the 54 economists surveyed by Bloomberg News said the Federal Open Market Committee will decide to start taking such steps at its September meeting.

Futures traders see an almost 60 percent chance the Fed will keep the benchmark rate at a record-low range of zero to 0.25 percent through to at least the end of 2014. The 10-year Treasury yield is likely to fall to 1 percent by the end of March and may touch 0.8 percent next year, Mizuho’s Takei forecast. It was at 2.71 percent yesterday, up from 1.72 percent when QE3 was announced on Sept. 13 last year." - source Bloomberg.

Looks to us that the S&P 500 is no doubt "Livin' On The Edge".

Oh well...

"To him that waits all things reveal themselves, provided that he has the courage not to deny, in the darkness, what he has seen in the light." - Coventry Patmore, English poet.

Stay tuned!