Over the past 5 months, we have been laying our views on the Economy and Financial Markets. In the process, we have been taking our readers on this journey as we have been building up our investment framework and related methodology.
We plan to review and monitor the Trend Following strategies we have covered in our previous two posts as summarized going forward on this website every month in the Beowulf’s Amory section of the website.
There are 14 tracking portfolios that are based on trend following strategies that we have previously covered in our posts. Trend following has a long history of academic and empirical support. Evidence suggests that trend following can be an effective means of avoiding large negative returns that coincide with traditional bear markets/drawdowns and we have demonstrated this in our prior post.
In the current environment, our Wave Runner strategy combined with any risk asset strategy would have protected investor capital in the latest drawdown/equity bear market we are currently seeing in risk assets thus far in 2022.
The underlying economic justification for trend following rules lies in behavioral finance tenets such as those relating to herding, disposition, confirmation effects, and representativeness biases. At times information travels slowly, especially if assets are illiquid and/or if there is high information uncertainty; this leads to investor under-reaction. If investors are reluctant to realize small losses then momentum is enhanced via the disposition effect.
Our global risk indicator which captures both fundamental leading indicators (Global Liquidity and OECD Composite Leading Indicator) and market sentiment, has been in Risk-off mode since January 2022 and invested in our Safety Portfolio. Table 1 below shows YTD 2022 results across all 14 portfolios relative to Benchmarks (AWCI MSCI All-World Index and the S&P 500).
In 2022, global equity markets have been impacted by interest rate normalization by global central banks and higher than expected inflation, which has reduced asset values which some indexes such as NASDAQ 100 (QQQ) down by >20% from the previous peak. This brings to mind a quote attributed to Warren Buffett when considering the current market, “When the [economic/liquidity] tide goes out you get to see who’s swimming naked.”
The reduction of liquidity/increase in interest rates has particularly hurt businesses that have benefitted from the ongoing liquidity support and cheap money in the recent past, which are financing growth with little to no profit/significant cash flow in the short term, and the potential for turning a profit is very far out into the future. When the price of money changes (interest rates), all asset prices are re-rated.
This ‘reserve wealth effect’ will potentially result in lower aggregate demand/consumption, and Central Bank hope to bring aggregate demand back in line with supply which has been constrained due to COVID-19 and the Russia/Ukraine war. The rebalance of demand/supply is thought to cool the highest inflation we have seen in a generation. Our trend following strategy has outperformed the benchmarks as 12 out of 14 trend following portfolios remain in positive territory for year-to-date 2022.
Our BT Momentum portfolio which reviews all 107 ETFs on a relative momentum basis across all asset classes (Commodities, Country, Sector, Factor Anomalies, Market-Cap, Fixed Income/Currency) and invests in the top 3 based on prior month’s relative momentum, has seen the highest returns at 21% year-to-date given strength of energy-related commodities (oil, natural gas, and gasoline) and restricted supply, which has protected capital on a real-returns basis given the current high inflation regime.
Table 1 – Year-to-Date 2022 Performance
What we are Watching Going Forward.
As we have explained in prior posts, the rate of change of parameters within the economy is a lot more important to markets, rather than the absolute magnitude or level. Whether or not the terminal Fed Funds Rate is 2.50% or 3.50% is less important than the overall rate of change in the cost of financing for businesses and households relative to their incomes.
Coming out of the COVID-19 pandemic, aggregate debt levels are larger than pre-pandemic, so it’s important to understand the relative changes in both interest rates, and corporate credit spreads.
These inputs are very important in the cost structure of many companies as they look to refinance maturing debt in a highly financialized economy and may have a significant impact on corporate profit margins, given the rate of change, as well as wage growth. Historically, corporate profit margins or reduction in demand, have been defended by temporary layoffs of workers.
In Table 2, we note historically (going back to 1965) as interest rates have increased (represented by 10-year yield), investment credit spreads and unemployment have increased with a 6-9 month lag as corporates look to protect profit margins as demand/consumption may reduce overtime in 2022 due to the ‘reverse wealth effect’ in both stock and housing markets. We note that in April 2022, interest rates have hit a 3x z-score, which has historically signaled a peak and is followed by a widening of credit spreads/higher unemployment in the next 6-9 months.
To date in 2022, labor markets appear strong with job vacancies outpacing unemployed and wage growth robust at ~6%, though running below inflation. The structural deflationary trends that existed before the pandemic still exist, namely, high debt levels, demographics, and innovative technology – are still there. Does high inflation change this calculus? It remains to be seen what the answer to this question is and our investment framework will answer this question over time, as our investment framework takes into account the rate of change and invests based on relative momentum based on the rate of change, we expect to see how higher interest rates may play out over time across asset classes. We do not need to answer this question correctly or have a correct forecast of these dynamics to see our investment portfolio benefit.
Table 2 – US Investment Grade Credit Spreads, Interest Rates, and Unemployment
We hope that you have found this informative and endeavor to provide updates to the 14 portfolios going forward every month.
If you are interested in implementing these portfolio strategies or had any
questions, feel free to contact us at beowulftreasury@gmail.com.
BT
