Monthly Archives: September 2015

Volatility: Risk & Opportunity

Capital markets are under pressure.  From a record high in mid July, US stocks (S&P 500) are down 8.6%.  Meanwhile, US bonds (BarCap US Aggregate) are down 1.6%, and international stocks (MSCI World ex-US) are down 16.3% from this year’s peak levels.  Volatility has surged in the last few weeks, with daily swings not seen in recent years.
As expressed in our last quarterly letter, we’ve expected an increase in volatility as a challenging earnings environment coincides with a turn in central bank policy.  The market is adjusting to ebbing central bank support for financial assets as the Fed approaches the first of potentially many steps in normalizing its extremely accommodative policies.  Exhibit 1 illustrates the unprecedented magnitude and duration of negative “real” interest rates compared with near-term inflation expectations.  After almost seven years of ultra low rates and liquidity provision that have coddled investors with a near absence of declines, investors will need to get used to a market that moves in more than one direction.
Exhibit 1: The Beginning of the End for Extremely Easy Monetary Policy
Fed Funds Policy Rate & Conference Board 1 Year Inflation Expectations (%)
A return to a more normal market dynamic is disconcerting for many investors, especially those caught offside with an extended risk stance.  For investors with valuation in their investment discipline and the flexibility to hold cash to protect capital, volatility presents opportunity.
In all of Augustine’s equity strategies, we raised cash holdings earlier in the year and are using the current environment as a way to buy assets at more attractive valuations.  Net of recent purchases, we still hold ample liquidity to take advantage of volatility.
We’ll need to be mindful to distinguish between a market correction and the beginning of a cyclical bear market.  At this point, we think we’re in the former.  Measures that have a strong historical record of providing an early signal for recession risk, such as the slope of the yield curve (still positive, see Exhibit 2) and leading economic indicators (see Exhibit 3) suggest a low near-term probability of recession.
Exhibit 2: Low Risk of A Recession in the US
Yield Curve Slope (10 Year – 2 Year %)
Exhibit 3: Low Risk of A Recession in the US
Conference Board Leading Economic Indicator
We hope this update provides you a sense of the defensive positioning we took ahead of the recent market gyrations and the opportunity we see in a volatile market.  Our aim in your portfolio is to achieve attractive risk-adjusted returns while being attentive to protecting capital.  If you have any questions regarding our strategy as stewards of your capital, please give us a call.  We welcome the conversation.