Risk Update – June 2019

It is that magical time of year again – the BIS Annual Economic Report is out! As always, it is full of insightful commentary and great charts. Well worth digging through.


This latest report, inevitably, touches on what is a very common theme at present; to what extent has Central Bank policy run its course? As we like to say the “we did ten years of extreme monetary accommodation and all we got was this T-shirt” complaint. If the objective of ZIRP, NIRP, QE, QQE, Twist, YCC, MLF, LSAP, LTRO etc was to elevate asset prices, then it has been a great success! If the objective was to build sustainable growth in the real economy, then apparently not so much we would argue.

There has been a steady stream of good write-ups about the clear failure (other than elevated asset valuations) of the Monetary Policy measures that have been undertaken throughout this cycle by the likes of Matt King (Citibank), Albert Edwards (SocGen) and Rob Subbaraman (Nomura). There was even a very technical note under the auspices of the BOJ showing that there is indeed something to the concept of the Reversal Rate (http://www.imes.boj.or.jp/research/papers/english/19-E-06.pdf). However, this was almost immediately refuted by Governor Kuroda recently when he chose to join the ranks of Central Bankers hinting that further easing was possible, even likely.

So, with all the economic doom and gloom leading to ever more calls for renewed Central Bank policy actions, what was the impact on markets? One of the best months in history for asset price appreciation. The below charts were produced by Deutsche Bank under the heading “This Has Only Ever Happened Once Before”. We don’t know if that is true, but the universal inflation of financial asset prices (or is it a debasement of the currencies they are priced in?) was impressive.

Figure 1: June 2019 Total Return Major Global Financial Assets
Source: Deutsche Bank/Bloomberg

The YTD figures aren’t too shabby either. Pretty impressive and adding credence to the insignificant nature of the short period of market shakiness late last year.

Figure 2: June 2019 YTD Total Return Major Global Financial Assets
Source: Deutsche Bank/Bloomberg

For anybody running a portfolio, it begs the question – are you running enough risk? Despite bonds having one of their best runs ever to start the year, their performance pales when compared to that of respective equity markets. What does it take to get somebody to own assets with greater upside potential? Regular readers know our answer, it is to have more effective risk mitigation in your defensive strategies. Replace traditional defensive fixed income, and other defensives, with explicit hedging strategies and own more equities. The ongoing compounding effect, as discussed at length in last month’s letter, continues to shine.

Figure 3: YTD SPX, US 10y Tsy, Dax, 10yr Bunds, SHCOMP, 10yr China Govt Bonds
Source: Bloomberg

Conveniently, the CBOE has just come out with an index that expresses what we regularly talk about and try to show in various ways. The CBOE VIX Tail Hedge Index (VXTH) tracks the return of a hypothetical portfolio that invests in the total return of the SPX and follows a formulaic hedging strategy using 1-month 30-delta VIX calls. Hopefully, you can see it within Figure 4 below, if not give us a call and we will share a larger version. In Figure 4 we have normalized performance of the SPX (total return), MSCI World Index, the Barclays US Treasury Bond Total Return index, and the HFRX Global Hedge Fund index. Squeezed in amongst them we have included the VXTH index, and two versions that we use historically of 75%/25% and 50%/50% of SPX and the CBOE Long Volatility Index (an index of “Long Vol” hedge fund managers). You will note, the 75/25 version tracks fairly tightly to the VXTH index. We think this gives a probable indication of what types of underlying strategies are prevalent amongst those managers.

Figure 4: Normalized SPXT, MSCI World, VXTH, 75/25 & 50/50 Long Vol and SPXT, US Tsy Bond, HFRX
Source: Bloomberg/CBOE Eurekahedge

We keep saying it till we are blue in the face, the key to compounding is performance in the wings. Participate in the upside and cut off the downside. How well are your traditional defensive strategies doing either of those? Based on the HFRX (yes, we know that is the “average”), absolute return hedge funds are not doing either. Fixed income, carry trades, short vol, all perform well in the mean, but are bounded on the upside and are increasingly correlated on the downside. Find an efficient long vol/convexity hedging strategy and take more beta risk. Stop paying fees for correlated risk. Stop “diversifying” with carry. Stop managing to short term, arithmetic returns, as we touched on last month.

Obviously, the performance series for Convex does not go back as far as the above charts, but we would be happy to show you comparisons to the above views overlaying Convex with various assets going back over the 7+ years of our existence. It makes for an interesting picture we think.

Central Banks seem serious about resuming increased monetary accommodation, despite asset prices being almost universally at historical extremes, and employment/growth/inflation numbers being anything but recession like. The SPX, as a proxy, has had up years in 8 out of the last 11yrs, including this year thus far, and only one of those years was up less than double digit percent (2016 up 9.54%). The entire industry tends to manage towards the mean, yet the market very rarely settles anywhere near the mean, it lives in the tails. It has nothing to do with being bullish or bearish, just simply the mathematics of compounding, and a sincere interest in doing what is right for the end capital owner.

Figure 5: Volatility ‘Comet
Source: Convex Strategies/JPMorgan
Figure 6: SGD/JPY ‘Seasonal’ Chart
Source: Bloomberg

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