Financial markets in the first quarter, as well as in the last few months of 2015, were characterized by uncertainty and high volatility. Expectations about the next interest rate decisions determined the uncertainty in the stock and bond markets while market participants seemed not to agree on the cause of the further decline in oil prices. Is it decreasing demand or a supply shock? In combination with financial markets that are more and more driven by models and technology, fast and extreme moves in both directions are the results.
Well-established seasonal patterns like the Christmas rally and small cap outperformance in January did not deliver their otherwise reliable outcomes this time. Moreover, successful long-term strategies and asset allocation models offered negative surprises.
The classic 60/40 approach not only suffered from the strong drawdown in equities. Depending on the positions in the 40% bond allocation (long-term, short-term, currency hedged, global, Emerging Markets), the familiar and anticipated compensation to offset equity losses did not occur.
CPPI models, for which the low interest rate environment already poses a huge challenge, were extraordinarily hit by those large losses in equities so early in the year. The risk budgets of many investors who use CPPI models or variations were eaten up in the first two months.
The classic trend-following strategies that came off brilliantly in 2008 lost some of their beauty amid the fast price moves over the last few months. On the one hand, the signal lines were far away, leading to a full participation in the drawdown of August with the exit following a few days later, for example. On the other hand, the number of signals increased and implementation often came too late or at high explicit and implicit costs.
The hedge funds of famous managers – some called legends – had one of their worst years in 2015. The negative performance continued into 2016. Not only the most aggressive strategies can be found among those funds but also those that are advertised as defensive, all weather or marked with another term that suggests low risk and stable returns.
Just because many established models and strategies failed or could not hold their promises, does not mean that all of those are worthless for the future. In case investors see no less value in the search and evaluation of active strategies, they can turn to passive investments such as ETFs. Still, one question is open: What allocation should be passively implemented with ETFs?
One interesting alternative to an active asset allocation and the answer to the last question is a new, passive asset allocation approach of Diversifikator GmbH, one of our clients. Although the approach sounds intuitive and easy, the resulting construct is innovative. The asset allocation is determined by all available global assets and their respective weightings. Beyond stocks and bonds, the asset segments commodities, real estate, infrastructure, private equity and farmland are included. These so called alternatives are often underrepresented in liquid portfolios. To consequently stay passive, ETFs that replicate the corresponding segments are utilized for implementation. The website diversifikator.com (in German) provides all information and gives full transparency on the approach. Users can see all allocations and build individual portfolios.
Have Commodities hit Bottom?
The oil price was one of the most important topics in the first quarter, similar to 2015. In our review for 2014 we wrote that oil – around 50 USD at that time – could fall further and stay lower for longer. This is what happened in 2015 and continued well into 2016. Even 30 USD for WTI did not hold. Our main argument for a continued low price level was the motivation of the cheapest producers to win back market share by pressuring the marginal producers with high output. The strategy turned out well, so far. Defaults increased significantly in 2015 and stayed on a high level in the first few months of 2016. The lost income threatens countries such as Venezuela and Russia.
Currently, with a low in February and a remarkable recovery until Mid-April, oil could have seen its bottom. The focus seems to shift away from oil and from commodities. Emerging Markets and the respective currencies gained some ground. Especially the oil exporting countries benefit from the recovery. Russia’s stock index added 14% in March while Brazilian equities gained 17%. Within our Emerging Market rotation Brazil replaced China/Hong Kong and, together with Mexico, now forms a pure Latin American portfolio.
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Do 5 Euro Coins indicate Inflation?
For the first time, coins with a notional value of 5 Euro started to circulate in the Eurozone. Issued as a collector’s item, the high notional value of the coin might have become necessary. For years now, market participants eagerly wait for official inflation numbers to judge if the central bank’s low interest rate policy bears fruit. Meanwhile, one statistic caught our eye. The German Bundesbank records counterfeited coins. Between 2011 and 2015, the recorded counterfeits of 1 Euro coins decreased by 13%, those of 2 Euro coins by 9%. These numbers do not describe the overall five year period but show the annual decrease! Assumed that people who pursue the illegal activity of minting switched to the more lucrative business of printing notes, machines that except coins became more secure, and also assumed that minting and commodities got more expensive (probably not within the last five years), then still the decrease in counterfeits seems very high. One explanation could be a lower incentive due to a loss in purchasing power of the coins. Then, inflation would be the reason for the decrease in counterfeited coins. Can you just take the inverse of the growth rates of counterfeited coins to receive an indication for inflation? The inverse growth rate of 1 Euro coins over the five years is 76%. In the same period, an investment in a broadly diversified ETF of European equities would have returned around 75%. Further interpretation is left to the reader.
Outlook
The second quarter started with a continued recovery for risk markets. The stabilizing oil price or new risk budgets that institutional investors received after the significant losses, might serve as the reasons. The heavy losses over the last months have revealed interesting opportunities. After years of growth stock dominance, we see value stock segments gaining momentum. A more sustainable signal for switching from growth to value was determined in December. Now is the time to systematically seize the opportunities but also to take another potential setback into account.