Natixis Global AM volatility experts say banks’ retreat from stimulus programmes will create significant volatility for years
Four volatility experts from Natixis Global AM Kevin Kearns,Vincent Chailley,Emmanuel Bourdeix and Michael Buckius warn that, with stock markets around the world inching higher, volatility may spike up at any time.
Kevin Kearns, portfolio manager Loomis, Sayles & Company
Too much debt in the developed world should continue to create volatility in the markets for several years, according to Kevin Kearns, head of Loomis, Sayles & Company’s Alpha Strategies group. “For Europe, Great Britain, the United States and Japan, there are really only four ways out of their unsustainable debt dilemma. You can grow your way out, implement austerity, default – either via a hard default or a soft default such as raising the age on social security – or you can print money,” said Kearns. What has transpired so far, and probably will continue to happen for some time, he believes, is a back-and-forth between all of these nations on which path is the least painful.
Kearns believes there are many opportunities to exploit volatility today, across multiple asset classes, including commodities, equities, fixed-income, and currencies. For example, techniques can be used to implement carry strategies, rate and credit curve views, and relative value opportunities (long/short) between cash and derivatives markets.
One spot Kearns sees for both offensive and defensive volatility plays is Japanese markets due to Japan’s unprecedented quantitative easing program, announced in April to stimulate that island nation’s economy. The expansion of their Asset Purchase Program by $1.4 trillion in two years is so large it is expected to double the money supply in Japan.
“It appears that the Bank of Japan is trying to engineer a 2% inflation rate – with negative real yields of 1-1/2% to 3% – and they want the investor to take on their bonds. The question is, will investors buy that, knowing Japan’s balance sheet is arguably the worst in the developed world, as well as knowing there are significant demographic challenges,” said Kearns. He points out that Japan has an unfavorable demographic for growing its way out of debt: by 2025 29% of the population will be over 65. Moreover, he reckons the country has the furthest to climb among the G8 nations.
“So far, the trade has been to be long1 on Japan’s Nikkei 225 stock index and short the yen. But the big question is, ‘What happens with Japanese interest rates?'” said Kearns. With the direction of interest rates in question, he believes there are a few attractive interest rate volatility opportunities to consider.
Overall, Kearns warns that the world has put a lot of faith in central banks, despite the fact that about half of all recessions have been caused by central bank policy mistakes. Therefore, he will be watching closely for volatility spikes over the next three to five years as central banks retreat from quantitative easing policies.
Vincent Chailley, Chief Investment Officer H2O Asset Management
Vincent Chailley, CIO at H2O Asset Management, an alternative investments firm in London, believes pumped liquidity of quantitative easing (QE) policies will continue to push asset prices up for a little while. But he cautions that investors should keep in mind that the longer central banks play at this game, the higher the payback price will be.
“Basically, you have a market where everything today is going up, slowly but surely. But we all know at some stage, and nobody knows when, all of these monetary policies will have to be normalized to get out of this extremely low rate situation,” said Chailley.
Chailley agrees with Loomis Sayles’ Kevin Kearns that central banks can make mistakes. And, if and when the market realizes this is the case with a QE exit strategy, it could trigger very violent moves in every asset class. “The only way to face this very possible situation is to start adding asymmetric strategies now, namely volatility strategies, to protect portfolios against this future extremely asymmetric event,” said Chailley.
Chailley believes volatility can be used in longer and non-short fixed-income investments to complement and enhance portfolio performance, as well as to reduce volatility and risk. One opportunity he sees for today’s transitioning fixed-income markets is to pilot relatively cheap strategies that may help protect portfolios against interest rate hikes in the U.S. over the next three years. “Currently, the U.S. market is not pricing in any sort of rate hike from the U.S. Federal Reserve until December 2015. So this may not be a bad proposal for complementing a portfolio,” said Chailley.
More and more, investors will come to consider volatility as an asset class, according to Chailley. “Volatility has proven to be one of the last ways to protect portfolios against risk today,” he said. Traditionally, investors have used assets such as currencies or gold to hedge their portfolio against any risk. But, Chailley points out, we see today that gold is down, the Swiss franc is pegged, and the yen is collapsing. Therefore, some of these once considered “safe haven” assets used for hedging strategies are now less appealing to investors.
Emmanuel Bourdeix, head of structured product & volatility management
Emmanuel Bourdeix, a volatility management veteran at Seeyond in Paris, sees a lot of similarities between 2013 equity markets and those of the low volatility era of 2004-2007. “We have quite the same configuration today. We had low interest rates in ’04 to ’07 like today. Huge flows of liquidity into the market pushed equity investors to a systematic buy-on-dips strategy. And typically, interest rates are too low today to attract investors again toward spending on hedges. That is why we have such contained volatility today,” said Bourdeix.
So far in 2013 the S&P 500 has recorded low daily price fluctuations. But Bourdeix warns that investors should not be complacent with today’s low volatility, just as they should not have been in 2007.
“If we expect volatility to remain contained, we also expect some transitory spikes, which will come from geopolitical events, social unrest or concerns regarding the exit strategy for quantitative easing,” said Bourdeix.
Bourdeix points out that the majority of equity investments globally are still benchmarked against indexes. He also emphasizes the anomaly of low-volatility stocks tending over time to outperform high-volatility stocks. This anomaly is directly linked to the behavior of equity investors who tend to overpay for the “glamour stocks,” overpaying for discovering the next Apple or Google, at the expense of “boring” stocks, according to Bourdeix. Typically, these low-beta, low-volatility stocks used in minimum variance strategies tend to outperform the market over a full market cycle while significantly reducing risk.
Michael Buckius, CFA, chief investment officer Gateway Investment Advisers
Quantitative easing is the big macro event that the markets are wrestling with today and will be for several years, according to Mike Buckius, a hedged equity manager at Gateway Investment Advisers. “This grand experiment that our central bankers around the world have been running has been going on for quite some time, and it’s the exit from this experiment that is the biggest source of uncertainty for investors right now,” said Buckius.
Although there is no clear exit strategy for quantitative easing, the unconventional monetary policies used by central banks in several developed countries to stimulate the economies after the 2008-2009 financial crisis, Buckius is hopeful that there can be a measured ending coupled with some economic growth in a few developed nations that could create a fairly benign exit event. Along the way, however, he does believe there will be bouts of higher market volatility as markets have difficulty digesting news of governments draining stimulus money out of their systems. Given this recipe for volatility, Buckius thinks it is prudent for investors to consider allocating a portion of their portfolio to volatility management strategies.
Buckius also believes investors should really consider volatility as an investable asset class. “I think it’s important for investors to take advantage of value wherever it is in markets. A source of return like volatility is a little bit unique, but I think what we’re seeing now as investors get more sophisticated, they are realizing there are investments other than stocks, bonds and cash,” said Buckius.