This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by John Davi, chief executive officer and chief investment officer of Astoria Portfolio Advisors in New York City.
Everyone wants to own risk assets right now. Bitcoin is up 1,000%, and pretty much every major asset class and region of the world has produced positive returns in 2017. This is rare, but not surprising—it’s all typical of late-cycle investor and economic behavior.
There’s good news and bad news that come with this environment. The good news is that the late part of the cycle can last several years, and sometimes the best returns can come at the end. The bad news is that timing the market top (or bottom) can be tricky, if not nearly impossible.
Right now, capital markets are swimming in an ocean of liquidity thanks to central banks flooding the system. However, markets trade on the margin and the rate of change will be different in 2018. Abundant liquidity, along with rock-bottom rates and extremely low volatility have driven investors to bid up assets such as real estate and bitcoin, among others.
What are the investment implications if liquidity begins to deteriorate on the margin? They can be quite significant.
We have benefited from this year’s rally in stocks and bonds (our Multi Asset Risk Strategy ETF Model Portfolio has a Sharpe ratio of over 3 this year—and that’s with no leverage), but we are managing our risk by incorporating asset classes such as gold through the iShares Gold Trust (IAU); liquid alternatives through the IQ Hedge Multi-Strategy Tracker ETF (QAI), long-dated Treasuries through the iShares 20+ Year Treasury Bond ETF (TLT)—each of which diversify our portfolio risk and carry well within an ETF portfolio construct.
Direct Link Between Liquidity & Volatility
Are you surprised VIX has been hovering around 10 for most of this year? Well, you shouldn’t be. There is a direct linkage between liquidity and volatility, as shown in the chart below:
Sources: Bloomberg, Astoria Portfolio Advisors LLC
This year, we have seen $2.2 trillion in central bank balance sheet expansion globally—approximately 15% of the aggregate balance sheet across the European Central Bank, the Bank of Japan and the Fed.
With low levels of economic uncertainty, low levels of earnings dispersion and ample liquidity, it shouldn’t surprise investors that VIX is “low.”
Several worlds are colliding. Earnings are improving, significant amounts of assets are moving into passive and systematic strategies (both of which de-emphasize the capital markets aspect that active managers historically implemented), and dispersion is rising. This combination is resulting in lower levels of realized volatility.
Changing Landscape In 2018
The markets, however, trade on the margin, and 2018 will begin to see liquidity decline in the U.S. The Fed has started to raise rates and wants to hike more, and quantitative tightening (QT) will further reduce liquidity. The repercussions are quite significant, especially on the margin.
For that reason, it’s not surprising that liquidity-sensitive asset classes such as U.S. high-yield credit, U.S. small-caps and Japan corrected in October and November. Historically, liquidity in capital markets starts to decline in Q4 as banks begin to wind down their balance sheet ahead of year end. Plus, we anticipate a December rate hike that’s already been priced into the market. The liquidity-based correction was likely in anticipation of both events.
We are watching financial conditions intensively, specifically the rate of change. It’s better to watch financial conditions instead of the VIX, because they incorporate financial stress in equities, bonds, money markets along with cost of credit. The VIX will likely react quickly should financial conditions deteriorate.
As you can see from the chart below, the Federal Reserve Bank of Chicago’s National Financial Conditions index is near a half-century low:
Sources: Federal Reserve Bank of Chicago, Bloomberg, Astoria Portfolio Advisors
If, on the margin, liquidity begins to decline in 2018 resulting from QT, fed rate hikes and other central banks ending their QE programs, there is a reasonably high probability that risk assets will suffer.
We doubt this liquidity risk is either consensus or built into the price. We remain constructive on risk assets, but we are also managing portfolios by incorporating asset classes that both diversify and carry well within an ETF portfolio construct. After all, calling the market top is virtually impossible.
At the time of writing, Astoria owned positions in GLD, IAU, SGOL, QAI, TLT and ZROZ throughout various portfolios we manage. You can reach John Davi at [email protected] or @AstoriaAdvisors. For a list of relevant disclosures, please click here.