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Good Times

As a child of the ‘70’s who used TV as an escape, I loved watching the classics such as The Odd Couple, Good Times, and All in The Family.  Forty years later, I am occasionally nostalgic, and will watch an episode of one of those great shows. But today, I am feeling even more nostalgic for the good old days of low market volatility but, alas, those days are gone.

The perceived omnipotence of monetary policy or, as Ben Hunt has labeled it, the Golden Age of the Central Banker, appears to be losing its potency. The last eight months have been bookended by periods of acute risk aversion marked by sizable equity drawdowns.  While the liquidity punchbowl doth overflow at the global level, growth is slowing or has completely stagnated, valuations are stretched and risks of all kinds are making headlines—economic, social, terror and geopolitical.  Adding insult to injury, we are witness to the most bizarre presidential election of the last few generations.  All of this leaves us longing for the good old days of low volatility and stable and seemingly always rising U.S. equity prices and perhaps a good TV sitcom.  Good times.

A Recap: A Tale of Two MarketsA Recap: A Tale of Two Markets

Early in the year, investors headed to the risk exits, stage left.  The U.S. equity markets experienced their worst decline to start a calendar year in their storied +100 year history; Chinese equity markets plummeted 20%, and oil prices reached a 13 year low.

After a lackluster “Santa Claus” year-end rally in equities, investors worried about slowing growth indicators in the U.S. and an earnings recession (two or more consecutive quarters of negative earnings); the rapid deceleration of growth and exploding credit bubble in China; Japan’s turning the page on a generation of stagnation only to usher in the beginning of a new one; a burgeoning liquidity crisis in the emerging markets driven largely by China’s slowdown and the dollar’s strength and social strife marked by populism domestically and abroad.

Volatility

As we expected, and have pontificated on often, volatility reigned supreme during the quarter. One of the easiest ways to measure this is very simple - via the number of trading days that the S&P 500 rose or fell by 1% during a given period. In Q1, this happened 26 out of 62 trading days, or 43% of the time, an average of two days per week. (For perspective, consider that during all of 2015, these +/- 1% moves occurred about 29% of the time)[1]. Interestingly, markets calmed down late in the quarter, with the last 12 days free of this phenomenon. We view this as simply a lull in the action, but a welcomed one at that.

International Concerns

Adding fuel to the negative sentiment, the Bank of Japan, seemingly desperate to catalyze their sloth-like economy, pulled another shiny tool out of the monetary toolkit: negative interest rate policy (“NIRP”). In previous blogs we have highlighted the growing preponderance of this across Europe. In Japan’s case, the BOJ decided to engineer negative rates on their own.  The logic seems to make sense—if banks will be charged to hold excess reserves at their central bank, wouldn’t that be a strong incentive for the bank to increase lending?  Perhaps on the surface, but we have not seen that dynamic play out when central banks have adopted NIRP.  Ironically, negative interest rates can compel banks to reduce their expenses and raise the rates they charge on consumer and commercial loans, which we’ve witnessed in Europe.

While Japan’s desperate measure may have spooked markets, the tipping point appears to have been investors’ growing concern that the Federal Reserve might join other countries in trying to spur economic growth by using NIRP. One of the catalysts was a direct question to Federal Reserve Chairperson Janet Yellen about the possibility of using negative interest rates.  She responded that tool could be available, if necessary. However, since that incident, the Fed has backed off suggesting that Yellen was simply answering the question asked; she had also suggested that the Fed would have to look into the legality of such a monetary policy accommodation. Regardless of her intention, the prospect of the world’s reserve currency having negative interest rates associated with it creates a “known unknown” in my mind—no one, including Chairwoman Yellen, knows what the 2nd and 3rd order effects might be on the global financial system.  

The market rebounded from the early-February low due to a variety of reasons including, but not limited to, the Fed dismissing this negative rate idea, China's near term economic stabilization (or perception thereof), and rising oil prices leading investors to believe that growth/demand have improved.

Portfolios in Review

The story of the first half of the first quarter was risk management.  At Threshold, we created our first risk management solution, Liquid Multi-Strategy (“LMS”), at the end of 2011 and the latest one, Dynamic Allocation Strategy (“DAS”), at the beginning of 2015.  The former had not been truly tested as we had not experienced a major equity drawdown since the strategy’s inception.  The latter, DAS, was launched on January 1, 2015, in response to our belief that volatility would return during the year marking a regime shift into a new environment of elevated volatility.  While both strategies had their challenges in 2015, primarily due to whipsawing of markets and one manager who failed to meet expectations, both performed better than expected by helping to provide protection and mitigate losses during the most acute drawdown in January through mid-February.

In 2016, we welcomed the addition of the newest innovation catalyzed by our research and development efforts, the Resiliency Strategy, designed to fulfill a similar role as LMS for those clients seeking an ESG-sensitive risk management strategy[2][3]. Resiliency's risk management attributes were truly tested with its January 1, 2016, launch and it did not disappoint as it mitigated 53% of the MSCI ACWI’s peak-to-trough drawdown year-to-date[4].

When markets turned around, the V-shaped pattern of the reversal left portfolios with those same risk management tools lagging, as expected. The cost of infusing portfolios with shock absorbing risk elements is giving up some of the upside.  The overarching objective is to capture even slightly less of the downside movements of the equity markets than the amount captured on the upside over a full bull-bear market cycle.  This last part is critical.  While the ACWI’s peak-to-trough move nearly breached -20%, I would not categorize what we have experienced as a bear market but simply a sizable correction.

Looking Forward

Most of the risks investors have been reacting to lately have been present in some form for years as highlighted in many of our blogs.  Prior to the summer of 2015, investors weren’t paying attention or were just undervaluing those risks.  We were due for an awakening within the context of slow/slowing growth, low inflation and, in some cases, deflation, a strong dollar exerting stress on emerging markets and putting pressure on U.S. multinational earnings from abroad as well as rising socioeconomic, safety and political concerns.

Conversely, we cannot ignore the potential for growth to reemerge.  One source could be lower commodity prices.  Since the middle of 2015, oil prices have been highly correlated with risk assets to an unwarranted extent. History actually tells us that lower oil and commodity prices, in general, are, oftentimes, catalytic to economic growth by dint of lower input costs resulting in higher corporate profitability and more discretionary income in the consumers’ pockets.  Furthermore, in the U.S., we have a number of positive developments including, but not limited to, unemployment remaining below 5%, bank loans increasing at a healthy pace annually, housing starting to show some signs of life, and an accelerating trend of capital looking to invest in innovations.

For an extension of this near record setting domestic expansion, I believe we need to start seeing policymakers taking the baton from monetary policy to initiate a systemic structural overhaul including tax reform, investing in upgrades of our dilapidated infrastructure, and augmenting our educational system to provide our youth with the skills to compete for increasingly sophisticated jobs, and entitlement reform.

Additionally, as we have talked about for a few years now, we have been awaiting three catalysts domestically—increases in consumer spending, capital investment by businesses and the resurgence of the housing market which has not come close to its historical contributions to U.S. GDP growth. U.S. consumers seem to be dipping into their wallets but we need some help from the latter two stimuli.

Concluding Remarks

I love this quote from Mohamed A. El-Erian, “In the last three years plus, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable in order to restore sustainability.”[5] We are in a tough spot from economic and market perspectives.  Globally, growth is generally stagnating with few exceptions and the “Golden Age of the Central Banker” is nearing its conclusion, i.e. the efficacy of monetary policy is being questioned and the results are becoming more and more muted.  As a result, volatility is our companion and wishing for the good times of low volatility and monetary jet propulsion to risk assets are fruitless endeavors.  

If you had been floating in outer space for the past seven years and landed on earth viewing the headlines of unemployment below 5%, near record low interest rates, annual federal deficits at approximately 2.5% (from a high of nearly 10% during the Great Recession)[6], the exponential rise in the global middle income class over the past generation, and an increasing global awareness and appreciation for  innovating and investing in ways to maximize the triple bottom line (social, environmental and financial) to create greater business value, you might think we were entering an age of prosperity.  

Our bottom line is this:  the only certainty is the uncertainty of how events will unfold in the future. And, yes we know the markets may occasionally throw out some ”Dyn-o-mite”. Within that context we need to prepare portfolios for a broad range of positive and negative scenarios.  In any given short term period we expect markets to test our resolve (and yours), trying to convince us that our focus on maximizing risk-adjusted returns is flawed. The good news is we have been tested before and our collective experiences as investors have trained us to exercise discipline in the face of short term market noise.  You hired us to maintain a level head during turbulent times and we are committed to doing so.  

Finally, I would be remiss without a reference to my all-time favorite sitcom, The Odd Couple, as markets displayed characteristics of both of the show’s lovable main characters in the first quarter. At times we watched the markets get so sloppy they reminded us of Oscar's bed in its full glory - half eaten stale bologna sandwich and the rest of the mountain of mess. During the second half of the quarter, Felix seemed to work his fastidious magic as markets bought into the central bank narrative with neat precision once again.   In a perfect world, we’d long for the best characteristics of both, but it is not a perfect world.

[1] Data source: Standard & Poor’s; S&P 500 daily returns.
[2] ESG refers to environmental, social and governance – three broad factors used as to measure the sustainability and ethical impact of a business and/or investment. 
[3] Forefront Impact Resiliency Strategy (“Resiliency”) is an investment solution developed through the collaborative efforts of Threshold Group and Forefront Analytics as of 1/1/2016. The strategy attempts to deliver an asymmetrical return profile of competitive participation during up markets and drawdown minimization during down markets – all while adhering to environmental, social and governance (“ESG”) standards commonly recognized by impact or mission-driven investors. Forefront applies quantitative risk factor diversification methodologies to the universe of ESG mutual funds and exchange-traded funds (“ETFs”) in an attempt to gain exposure to the risk factors that they believe the market rewards over time.
[4] Performance of the first account invested in the strategy. Mitigated refers to the difference in the strategy’s drawdown v. the market (MSCI ACWI) as a percentage of the market’s drawdown. Time period for drawdown reference: 1/4/2016 through 2/11/2016. Net of Forefront’s manager fees but gross of Threshold Group fees.
[5] Mohamed A. El-Erian, “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse,” (Random House, 2016).
[6] Federal Reserve Bank of St. Louis

©2016 Threshold Group is a Registered Investment Adviser.
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