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February 2018

Multi-Asset TeamBALANCING ACT
Nikko AM Multi-Asset’s global research views

SnapshotIn our 2018 outlook, we made the case for rising volatility as
central banks across the developed world slowly remove thestimulus punch bowl, but few would have imagined volatility
spiking with such a vengeance as it did in recent weeks. VIX,
the index for implied volatility, jumped more than 100% in asingle day, in fact in a matter of hours, which had never
happened before. Yet it is hard to point to a catalyst that iseven closely proportionate to the spike – i.e. there was no“Lehman Brothers” event in sight.
Equities began to sell off ostensibly driven by inflation fears
capped by a strong jobs report early in February, but the spike
erupted from a “short volatility” ETF, requiring the investment
manager to buy volatility (cover their short position) thatsqueezed the VIX higher in a very short period of time.
These ETFs had grown quite popular in recent years, attracting
investors with extraordinary performance. The Velocity Shares
Inverse VIX ETF returned 135%, annualised over 2016/17 but
then “poof” it went to near zero in a matter of hours.
Chart 1: Velocity Shares Inverse VIX ETF

The volatility spike that began with these specialised ETFs was
likely amplified by programme trading including risk parity
and commodity trading advisors (CTAs) where higher volatility
necessarily requires a position unwind. The shock so far
appears orderly and contained, unlikely to shakefundamentals, but bears close watching.
Higher volatility is likely here to stay given developed market
resolve to tighten. What’s more: the US Federal Reserve (Fed)put may be more out of the money than once believed withNew York Fed Governor Dudley calling the selloff “small
potatoes”, perhaps signaling a new era where central bankers
are willing to accept higher volatility.
Welcome back to the old normal where volatility is a more fairreflection of actual risk, keeping investors honest as there is nofree lunch. Could this be the end of the bull market? We do notthink so as fundamentals remain strong, but it will be a rockier
road requiring careful portfolio construction emphasisingvalue, quality growth and downside protection whereappropriate.
The current high level of volatility is more a distortion driven
by programme selling than it is a reflection of true inflation
risk. We do expect a rise in inflation, but more of the healthyvariety, lifting wages and commodity prices as a function ofhealthy demand. It is possible that less benign inflationarypressures may begin to build, but the bump-up in yields has
already been significant and is a natural stabiliser to reduce
inflationary demand pressures.
In our view, the bigger risk is that the return of volatility could
destabilise corners of the market that had grown toocomplacent, forcing further deleveraging. Volatility builds inconcentric circles taking out the most leveraged first, but can
extend to include those more modestly leveraged, beginning anegative feedback loop with deteriorating fundamentals.

Source: Bloomberg, 2018

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The beauty of rising volatility is that it presents opportunities
for those not forced to sell assets (or buy volatility).
Programme selling will often leave bargains on the table forfundamental investors to buy, so we cautiously welcome
higher volatility while recognising its potential to overshootand cut into fundamentals.

Asset Class Hierarchy (Team view1)

Much of this is due to the dollar remaining weak and credit
spreads tight, but we also note that financial conditions canshift quite considerably in a short period of time. To date, therise in yields, spreads and the dollar have tightened conditions
at the margin, but so far conditions remain easy still in support
of fundamentals.
Chart 3: Goldman Sachs U.S. Financial Conditions Index

Note: Sum of the above positions does not equate to 0 in aggregate –cash is the balancing item.

The asset classes or sectors mentioned herein are a reflection of theportfolio manager’s current view of the investment strategies taken
on behalf of the portfolio managed. These comments should not be
constituted as an investment research or recommendation advice.
Any prediction, projection or forecast on sectors, the economy and/or
the market trends is not necessarily indicative of their future state or
likely performances.
1

Research Views
We lifted the US up the global equities hierarchy, justabove Germany, on the back of a macro upgrade due to strong
earnings momentum.
US equities continue to remain expensive though slightly lessso after the recent selloff, while momentum remains positiveand earnings continue to improve. As shown in Chart 2, theS&P 500 rise is a largely reflection of the forward earnings
outlook. After the corporate tax cut late last year, earnings
expectations leaped on the prospect for improved margins
and the S&P500 followed. These gains were erased in the selloff, yet the improved earnings outlook is unchanged.
Chart 2: S&P 500 vs S&P 500 earnings forecast

Source: Bloomberg, 2018
Our global credit hierarchy remains unchanged, favouring
investment grade (IG) in the US, Asia and Europe, withpreference for the US within high yield (HY). Credit remains a
key asset class to watch closely in the current environment, as
concentric circles of volatility often reach lower quality credits.
Stress in credit markets is an indication that rising volatility
may be feeding back negatively to fundamentals, potentiallyjustifying a reassessment of economic health.
Almost all credit markets are still looking expensive evendespite the selloff to date, with little room for further spreadcompression. However, this is to be expected at this stage inthe cycle, as improving global growth and therefore improving
cashflow continues to support demand for carry.
Asia IG’s option-adjusted spread (OAS) versus US IG is around
its three-year average of 24 basis points (bps), but with 2.25
years lower duration, making Asia IG attractive in the current
environment of rising yields.
Chart 4: Asia IG vs. US IG Spread & Spread Duration

Source: Bloomberg, 2018
Despite monetary tightening in the US, financial conditions
have continued to ease – in fact, reaching the easiest levels notseen since 2000 at the height of the last technology boom.
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Source: ICE BofAML, Bloomberg, 2018

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BALANCING ACT2018 will be another record year for Asian IG issuance, though
redemptions are expected to keep supply contained while
local demand is still firmly supported.
USD IG issuance supply is expected to increase, while demand
may decrease at the margin as European and Japanese
investors are punished by increasingly higher currency
hedging costs or a weaker dollar in the case of those choosing
not to hedge – a new dynamic described in the sovereign
section.

to broader averages given that investors are likely to ventureabroad for a more attractive yield.
However, increasing currency hedging costs diminishes therelative attractiveness. Over the past year, a fair contingent ofJapan investors chose to own Treasuries unhedged, benefitingfrom the positive correlation between yield and the dollar.

0.5

If you lost money on a rising yield, such losses would typicallybe mitigated by dollar strength. But this relationship broke
down in January where yields rose but the dollar instead also
sold off as shown in Chart 7, exacerbating the pain ofunhedged exposure.

0.0

Chart 7: JPY spot vs US 10-year yield

Chart 5: Hedging Costs of USD for EUR and JPY Investors

-0.5
-1.0
-1.5
-2.0
-2.5
12

13

14

15
EUR

16

17

18

JPY

Source: Bloomberg, 2018
Our global sovereign bonds hierarchy remains
unchanged from last month, favouring Australia, the US andthe UK. Sovereigns suffered a rout throughout the month withUS Treasuries taking the brunt of the losses but Germany not
far behind, as shown in Chart 6. We have long been cautious
on sovereigns due to expensive valuations, negative
momentum and monetary tightening especially as reflation isturning to concerns for inflation that is lifting the long end of
the curve.
Chart 6: Global Sovereign Returns in January 2018 (Local
Currency)

Source: JP Morgan, Bloomberg, 2018
So long as the dollar and bond yields sell off together, foreign
demand for treasuries can remain weak while supply is set toincrease not just from recent tax cuts (and potential fiscal
stimulus later this year), but also for the reduction in the Fedbalance sheet. These supply and demand dynamics areunfavourable, but part of it is currently fear driven, which islikely to dissipate if inflation reports more benign than many
seem to fear.

Commodities remain attractive for valuations, momentum
and macro fundamentals. As shown in Chart 8, the ratio ofcommodity prices over the S&P 500 has never been lower all
the way back since 1970, indicating strong underperformance
relative to equities. One would expect equities to outperform
commodities over the long run given real earnings growth, but
given that our models show commodities cheap and equities
expensive, the potential for mean reversion of this pricerelationship is high.

Source: Bloomberg, 2018
Typically, sovereign yields are relatively tethered acrossgeographies where a sizable jump in one tends to mean revert

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Commodities strongly outperformed equities in the 1970s, in about of stagflation. The subsequent peaks in 1991 and 2008
were less about inflation and more about demand exceeding
supply. In the current environment, inflation looks like it ispicking up while supply remains stagnant and demand
continues to pick up. The S&P is very expensive, so it is notdifficult to see how commodities may have their day soon.

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BALANCING ACTChart 8: Ratio of S&P GSCI Total Return over S&P 500 Index

Process
In-house research to understand the key drivers of return:
Valuation
Momentum
Macro
Quant models
to assessrelative value

Quant models tomeasure asset
momentum overthe medium term

Analyse macro
cycles with tested
correlation to asset

Example for
equity use 5Y
CAPE, P/B & ROE

Used to inform
valuation model

Monetary policy,
fiscal policy,
consumer, earnings& liquidity cycles

N

N

ExampleSource: Bloomberg, 2018
JPY was upgraded above USD on the global currencies
hierarchy. For some time, JPY has remained at or near thebottom of the hierarchy for its stated policy of managing theyield curve having the effect of weakening JPY as the Bank ofJapan (BOJ) was forced to print money to buy Japanese
Government Bonds.

+

Final Score +As it turned out, BOJ jawboning did most of the job for themas the stated policy pushed markets to keep yields steadywithout requiring much in the way of BOJ purchases. In fact,
asset purchases declined quite markedly in 2017, below the
bank’s projections early in 2017.
The asset purchase programme had once seemed focused on
weakening JPY relative to the USD in the BOJ’s quest to lift
inflation while stimulating exports and corporate earnings.
However, Japan finds itself increasingly integrated as part of
the China supply chain, where JPY strength relative to USD isless relevant. As we have noted for some time, equities haveremained resilient despite JPY strength relative to USD.
To date, positioning has been significantly short JPY on thepremise that the BOJ’s managing its yield curve will result inasset purchases resulting in a weaker JPY. But this is now lessthe case, leaving JPY stronger at the margin, just as investors
are less inclined to currency hedge equity exposure given that
equities are more resilient in the face of a stronger currency.
JPY remains inexpensive and with improving momentum
supported by these above described dynamics, we lifted it up
the hierarchy, just above USD.

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