Category: Alternative Investment Strategy

Current views on asset allocation in fixed income and credit are generally negative. The focus should be on holding shorter duration and cash investments.

It does not take much for an investor to have a losing credit trade on long duration bonds. The average duration on a long-term 10-year corporate is around 8 and current OAS spreads for triple-B corporates are 160 over Treasuries up from 120 earlier in the year. Half this move will take investors back to levels seen in 2016 and wipeout all of the spread compensation for a year. This is not an extreme bet if we have any further erosion of equity prices or change in credit risk expectations, (See Corporate debt growth has exploded – The added macro shock sensitivity creates real risks.) Shorter duration corporates will be at less risk given their lower duration but the stocking up of credit for yield reaching can be painful if credit risks increase.  

Diversification is usually thought of as a longer-term concept. Don’t worry if it seems like you are not receiving diversification in a given month or quarter. Think about diversification across a longer horizon.  Diversification also does not guarantee better returns for a portfolio. Negative diversification does mean that your losers will be offset with winners.

When markets reprice risk, it is not fun being a trend-follower. Long equity indices were a crowded trade and few made money when the early October reversal hit the markets. Fast traders were able to exploit the move, but a bounce off the lows hurt intermediate traders. Bonds were hit with the cross-currents of flight to safety against the continued threat of growth and Fed action. Currencies were hit with this repricing and not a place of profit able trends. 

Simple assumptions to some classic monetary models will produce very different policy views for the direction of Fed action. These significant policy divergences are the reason for the recent pick-up in bond trading. A dispersion of opinions on Fed action will lead to more volatility, trading, and potential rewards in these markets. 

With all of the discussion on news, “fake news”, misinformation, and opinion, it is important to focus on some first principles for investing and narrative as news. The narrative is not the facts from an announcement, but the story surrounding the price move coupled with facts. For any investor, it is important to realize that narrative generally follows prices, and prices do not follow narrative.

Managed futures performance for May was driven by one sector, global bonds. The surprise events in Italian politics led to a flight to quality move into safe bonds around the world. This sharp reversal caught most short trend-follower flat-footed. The commitment of traders reports have shown a strong short tilt in managed money. The size of the move over less than 10 trading-days ensured stops would be hit and positions changed. The question was just how much pain managers took in this sector. Notably, the markets sold-off on the good economic employments numbers to further hurt managers who switched to longs earlier in the week. A similar set of events followed the rates markets. Expectations for fewer Fed hikes given the political turmoil only reversed again after the US employment number.

One way to measure market uncertainty is to run a simple thought experiment. A well-behaved market should match performance with events in a well-defined manner. An uncertain complex market environment would behave in an ill-defined manner. Close your eyes and assume you have knowledge of the news highlights for the month of May. For example:

Political turmoil in Italy and the EU
Off-again/on-again North Korea talks
Good economic data albeit with lower momentum
EM problems in Turkey and Argentina
Trade war discussions