The combination of the global health pandemic, equity and commodity correction, oil war and business shutdown are extraordinary. The gravity of this situation and the follow-on implications are difficult to comprehend. How does one weather the current storm and prepare for what comes next?
Equity and Stimulus
The amount of stimulus implemented by global governments and central banks is unprecedented. Trillions. Yet, will it matter? Some believe it will and the equity market will bottom and rally sharply to new highs. Many feel it will be largely inconsequential given this is a health issue and improvements in the war on coronavirus will be far more stimulative than economic incentives no matter how great. The reality is the economic implications for asset prices is difficult to determine with so many unknowns. As such, we believe there remains significant downside risk for equities. Given that the Q1 correction of 20% (S&P500) merely takes the "top off" the rally, the market is still higher than where it closed at the end of 2018. Are we better off than we were at the end of 2018? We don't think so. Moreover, we surely know it is far more volatile. Anything could happen.
What are the safe havens?
When we look for safe havens, the bond market has generally made sense. In March. after selling off in tandem with the equity markets, bond prices have indeed rallied. However, this safe haven status is related to the credit status of the issuer, often a government, and even this may be a concern going forward. Given the extent of stimulus and thus low rates (in some cases negative yield), the investment opportunity for traditional fixed income sector has been compromised to say the least.
While many have viewed gold as the hedge or safe haven, I hope this has been debunked. What is it anyway? Commodity? Currency? Some say "now is the time" but I say, where was the protection when needed as equity dropped 30% in the first two weeks of March 2020? Bouncing at the same time as the stock market doesn't make us feel much better in the last two weeks. Yet, many argue that now that the commodity shock has occurred, gold has the ability to act as an inflation hedge. To that we say, maybe.
Inflation
Given low interest rates and relatively strong US dollar, many believe there is a low risk of inflation. In normal times we would agree. However, we believe there is significant risk of unexpected inflation, the worst kind, from here. "Wartime finances that balloon budget deficits that are covered by money printing have proved inflationary through history." Per Julian Bridgen at Macro Intelligence 2 Partners, “...we are now entering an era of monetarily financed fiscal policy, just as the trend to de-globalization accelerates. This is going to be very inflationary”. Moreover, we fear supply chain disruptions may have significant implications for prices of goods. Given commodities are at extraordinarily low levels, there is a logical risk of higher prices due to lack of supply.
We believe a far better bet is spreading that opportunity for commodity appreciation beyond gold. Tactically, you want to own what is moving higher and in doing so it helps to be agnostic to what it is. Perhaps it is grains because of food costs, metals such as copper indicating the economy is picking up, or perhaps energy starts to rise after a 50-60% haircut exacerbated by an OPEC market-share war on top of demand destruction due to COVID-19. These are very real risks that affect the pocketbooks of individuals and companies alike. Real inflation.
Given commodities generally started to sell off in early in January and look to have been the "canary in the coalmine" of the global economic engine, is it possible they start to react to increased activity and/or a lack of supply quickest? While this depends on the market, it highlights one of the core benefits of commodities as a diversification tool: there is a ton of diversity within the commodity sector itself.
Portfolio Diversification
What the sell-off since peaking February 20th has reminded us, is that in times of crisis driven by incredible forces with deep economic implications, many assets become highly correlated. We have seen equities fall alongside commodities and many typical alternatives including private equity, infrastructure, and even real estate. Many of these assets are considered "diversifiers" for a portfolio, yet time and time again we realize that in during stress they do the same thing. The reality is that the entire rally over the last decade has been characterized by a low volatility grind higher followed by the odd, quick correction and subsequent recovery. This has happened over and over again. This is what convergent return streams do. There are few asset classes that counterbalance this given few are divergent (see graphic at side and definitions below).
Definitions:
Convergent return streams are characterized by many small gains with occasional devastating losses. Typically, the upside volatility is low while downside volatility is higher (negatively skewed with positive returns). Strategies are often based in fundamentals given the human tendency for logical sense. It is a “human” feel good strategy that gives investors constant gratification. Most active and passive investment strategies and alternatives fall into this category and behave like equities even in crisis.
Divergent return streams are characterized by many small losses with occasional big wins. Typically, the upside volatility is high while downside volatility is low (positively skewed with positive returns). Strategies are often non-fundamental and based in repeatable rules-based process and are agnostic to market direction or asset type. This return stream may at times feel “inhuman” without constant gratification, alike paying a premium. Returns are most commonly derived from trend following, common among CTA/managed futures/quant managers and may show up as “crisis alpha” at times when convergent returns are suffering.
One of the few asset management sectors that are indeed divergent historically are Commodity Trading Advisors (CTAs). These are managers that are agnostic to market direction, participate in all markets both financial and commodity, with the goal of providing a positive, but non-correlated return to a portfolio. Some call them "Quants" as the investment strategy is typically scientific, unemotional, risk management based and ideally negatively correlated at the right times. This is often referred to as "crisis alpha", the ability to earn superior risk-adjusted returns during crises.
However, this isn't happening for all CTA managers. Those who became enthralled with keeping up with the overvalued equity market, adding more equity and financial exposure in general have not performed well during this recent period. The “crisis alpha” expected from many CTAs has not shown up. Benchmarks representing CTA managers were down in 2018 as markets corrected and are again down in Q1 2020.
Auspice has a history of performing at these times of need dating back to our inception in 2006. Our outperformance has again shown up 2020 as true crisis alpha and we are working hard to make sure this continues.
The volatility and unknowns are likely to bring about many more surprising trends. This will occur beyond equities in currencies, bonds and especially across the diverse commodity sector. This will likely provide a series of opportunities for our disciplined approach. We anticipate this period lasting for the rest of 2020 and into 2021. We are very excited to help you weather the storm. Please feel free to reach out for more information.
Disclaimer below
IMPORTANT DISCLAIMERS AND NOTES
Futures trading is speculative and is not suitable for all customers. Past results are not necessarily indicative of future results. This document is for information purposes only and should not be construed as an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice. Auspice Capital Advisors Ltd. makes no representation or warranty relating to any information herein, which is derived from independent sources. No securities regulatory authority has expressed an opinion about the securities offered herein and it is an offence to claim otherwise.
QUALIFIED INVESTORS
For U.S. investors, any reference to the Auspice Diversified Strategy or Program, “ADP”, is only available to Qualified Eligible Persons “QEP’s” as defined by CFTC Regulation 4.7.
For Canadian investors, any reference to the Auspice Diversified Strategy or Program, “ADP”, is only available to “Accredited Investors” as defined by CSA NI 45-106.