This week has been a busy week for market impacting news and economic data releases. We saw the Bank of Canada hold its key overnight lending rate at 0.75%, the ECB discuss its ongoing QE program, Greece still negotiating with the IMF its loan repayments, Corporate America begin reporting quarterly earnings, and overnight we saw the Chinese regulators strengthen their margin lending rules and permit greater short lending by their banks. So lots of market moving news that when aggregated has resulted in flat equity markets, lower bond yields, higher commodity prices, and a stronger Canadian Dollar.
An essential factor in our management of your portfolios is how these events interact with each other from a risk perspective. The bedrock of traditional portfolio management has been asset allocation, but risk management must be increasingly integrated within this process as we witness fundamental changes to interest rate policies and volatility around the world. When it comes to the traditional “balanced” management of bonds and equity, it is our opinion that effectively reducing risk while providing a positive return will become increasingly difficult as the correlation between asset classes rises.
To best illustrate this point we turn to historical returns over the past 100 years and the correlation of those returns over the past three decades. What we found was that during periods where the financial environment was dominated by rising interest rates, higher unemployment rates, volatile energy and commodity prices, along with increased government regulation and involvement in the economy, such as the 1960’s and 70’s, we saw traditional assets such as bonds and equity return 1.5% in total over that entire 20 year period. Just like market returns, the correlation between asset classes is also not a static measure, and what concerns us is that over the past three decades, the correlation of monthly returns between equities and fixed income has increased.
The basic principle of diversification is to own a number of investments that move independently, up and down, based on distinct and differing catalysts. As this independence erodes the net result is that the diversification benefits of traditional asset allocation are becoming less and less effective. What institutional studies have shown is that portfolios that prioritize risk factors are more resilient during periods of market turbulence, so it is not surprising that we have seen Pensions, Endowments and Foundations increasingly move towards a risk-based approach to asset allocation.
When we analyze risk as part of the portfolio management process we are aware of the unintended biases and the negative effect that increased asset correlations have on a portfolio. Consistent with our commitment to providing our clients with better tools to manage their risk, we will increasingly incorporate strategies that prioritize risk management.
When it comes to risk, what we are ultimately concerned about is the size of any portfolio loss, how long the portfolio is down and how often a loss occurs. This is best performed on a portfolio basis rather than an individual holding basis, as it is not only unrealistic, but impossible, to hold assets that only go up and never hold assets that go down.
Currently in the United States the Securities and Exchange Commission (SEC) is preparing new asset management rules that require asset managers to utilize enhanced stress testing requirements. A stress test is the process of looking at different scenarios to evaluate and understand risk potential and vulnerabilities within a portfolio. We will be focusing utilizing our own stress tests to employ strategies that properly place investor return needs ahead of “benchmark” performance such as market neutral, arbitrage, and long / short which should deliver greater consistency within the ever changing financial environment.
North American equities are down fractionally this week. After positive earnings results at some US financials and technology companies earlier this week, disappointment in transportation stocks such as rails shook markets. This string of good-then-bad earnings mirrors the market behavior and could be the first quarter since Q1/09 where S&P 500 EPS growth is negative (-2.0% so far). After this short period of volatility, our hunch is for better markets in May and June before a summer break.
Regarding economic statistics this week, in Canada, retail sales rebounded nicely in February and are now up 2.5% over the previous 12 months. Inflation has also staged a comeback, up 1.2% over this same period. Finally the International Energy Agency is now forecasting growing global oil demand in 2015, thus oil prices have surged this week. Regarding the US economy core inflation remains near the Fed target at 1.8% year over year. In Europe, the ECB made it clear that it will stick to its QE plan despite some signs of economic improvement. Who would have thought that German 10-year bond yields could turn negative?
At home in Vancouver the forecast calls for blue skies and sunshine, so enjoy the weekend and take advantage of the beautiful weather.
We never forget that working for our clients is an expression of your trust, and we promise to always uphold that trust. Thank you.
As always, we welcome your feedback.
The Dekker Hewett Group