What future for ETF investors – anyone for a regime change?


Judging by the huge ETP positions linked to volatility in the United States, there is almost certainly an army of investors betting on an imminent correction. A parallel debate focuses on the outlook for inflation / stagflation, while another debate revolves around the possibility of another tantrum after an episode of monetary tightening. In a sense, all of these debates are interrelated.

At its core, these debates revolve around whether we collectively believe that multiple turning points are likely to emerge in the coming months. In no particular order of importance, I would highlight three key debates:

  • Is this the start of an inflationary cycle?
  • Is this the beginning of the end of QE in its current form?
  • Is this the peak of the bubble and do we have to go through a big market correction?

In recent months, each and his mother have been throwing their analytical tools on these debates. As you can imagine, the answers are about as clear as mud, surrounded by a multitude of cautions and warnings.

Analysts at French investment bank Societe Generale, for example, have attempted to answer the obvious question of the tightening: If policy tightens, which asset classes could do better?

In the bank’s regular publication Practical Quant Investor, analysts reminded us that the consensus is that “an accommodative policy should support the valuation of stocks by lowering the cost of capital and boosting economic activity and overall corporate profits. , while a monetary tightening would lower stock prices given its higher implicit discount rate and / or lower expected economic activity and aggregate profits ”.

The problem, of course, is that different monetary regimes are associated with different political regimes, with loose monetary policy tending to coincide with recessions and low economic growth, while restrictive monetary policy and rising interest rates are usually. indicative of a stronger economic outlook, particularly in times of subdued inflation, which supports strong equity performance.

It is – as political economists like to remind everyone – dependent on the regime. However, recent data from the last decades gives us some clues. The most recent tightening cycles, for example, have not coincided with runaway inflation and have therefore been positive for equity investors (see Charts 1 and 2). SG analysts observed that the “S&P 500 has posted annualized returns of around 12% per annum during tightening phases compared to only around 4% during phases of monetary easing in the 30 years since 1990” .

And what about the different factors and styles within the equity space? “At the equity level, cyclical strategies, especially value and size, tend to fare better during monetary easing, in part because the easing phase overlaps with the early economic recovery period of the cycle. economic which is very conducive to a cyclical rebound.

Defenses such as quality and low volatility are struggling during the tightening phase with the economy in charge and the markets rallying. On the other hand, compared to their challenges during monetary easing, growth-oriented strategies including profitability that targets high-quality profitable companies and secular growth strategies tend to work well. during the tightening phase. “

Nicolas Rabener, Founder and CEO of FactorResearch, tried to answer a different question: What to invest in if you think inflation is about to become a more persistent challenge. In a recent report, Rabener creates a framework for selecting asset classes from a set of 59 indices strongly correlated to the 10-year U.S. inflation break-even point using daily data and a one-year retrospective analysis. . More precisely, he selected the 10% of the most correlated indices, which results in a concentrated portfolio of six stocks. The index set includes all available asset classes – stocks, bonds, commodities and currencies.

An immediate challenge becomes evident: Daily inflation data is only really available from 2006, with a range of 0% to 3% for key inflation rates. This is far from a rerun of the 1970s! Figure 3 shows the difficult conclusions. While investors might have expected a portfolio dominated by commodities like energy or gold, in reality an inflation-proof program looks extremely eccentric and would have featured a range of pairs of currencies (AUD / JPY and CAD / JPY) plus fuel oil, natural gas and oil.

As Rabener reported: “The majority of the portfolio consisted of specifically developed currency pairs and market currencies like USD and GBP against JPY. Japan’s inflation rate has been close to zero for the past two decades, while countries like the US and UK have slightly positive inflation, which is reflected in the performance of these pairs.

Hiding not so subtly at the bottom of all these debates is an obvious truth – what really matters over the next few years is political economy. We can throw any macroeconomic and financial model to these challenges, but very quickly we come back to politics. Are we about to enter a new political era in which old financial models become much less relevant? In other words, when we say “regime change”, aren’t we really talking about political regime change?

Vincent Deluard, global macro strategist at StoneX, is honest to say the least about this politico-economic dimension. Last month he published a fascinating note, titled A calculated bet: five alternative 60/40 portfolios for the 2020s, which place the change of political regime at the heart of the strategic debate. And he points out, rightly in my opinion, a key point – that the classic model of portfolio diversification, the 60/40 portfolio – no longer works. “The golden age of lazy asset allocation is over,” said Deluard.

Deluard’s innovative response is to build five portfolios consisting of 60/40 covers. In each portfolio, a key political risk is treated with a binary hedge between two different asset classes. In no particular order, these five are:

  • China slowdown: international value stocks / Chinese government bonds
  • Secular Growth: US / Latin American Pharmaceutical Bonds in Local Currency
  • Super fragile / anti-fragile: Super fragile (Taiwanese stocks and European banks) / anti-fragile (gold, bitcoin and yen)
  • American Renaissance: American infrastructure, house[1]US regional builders and banks vs big tobacco, long-term treasury bills
  • Geopolitical risk: India / Africa and frontier markets vs Russian bonds

As Deluard correctly observed: “If investors want high single-digit returns in the 2020s, they have to accept that volatility will exceed the smooth returns that the 60/40 portfolio has provided over the past four decades. They should also be prepared to invest in risky places, such as Russia and Taiwan, esoteric assets, such as bitcoin, and ugly sectors, such as European banks and local currency bonds in Latin America.

The past decade has rewarded the lazy and the conformist: Passive ownership of the biggest stocks combined with a defensive position in the world’s risk-free assets was enough to generate high single-digit returns with minimal volatility. In the next decade, success will be determined by the courage to think outside the box and the ability to combine these risks intelligently.

My own view of these debates is, as might be expected, cynical of far-reaching claims. I am not convinced that we are on the brink of an inflationary precipice. I also don’t think we’re getting any closer to war with China. And when it comes to the markets, I am not yet convinced that we are at the peak of the bubble. But once we dig into the political regime changes, big changes are evident.

Take monetary policy for example. The risk of policy error is great – a central view of Deluard – but that’s because central bankers have come too close to the progressive view that inflation is only one risk among so many. others and that running a hot economy is a great idea. Additionally, I suspect that in the next recession or recession we will see new monetary weapons introduced, such as a weak form of MMT.

As for fiscal policy, it seems obvious to me that tax rates are increasing to finance increased public spending. This in turn is likely to lead to increased risks of running a hot economy to achieve full employment.

As for globalization, it seems to me too early to call the peak of integration – alternatives to China like Vietnam are booming. That said, it’s hard not to believe that with governments and large corporations concerned about extended supply chains, some form of localization won’t have a big impact.

How these things play out in terms of the portfolio is fully taken into account, but I would say there is a likely scenario: political and financial volatility will start to rise again.

This article first appeared in ETF Insider, ETF Stream’s new monthly ETF magazine for professional investors in Europe. To access the full number, Click here.

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