Market Upside Down: How to Invest Profitably in a Shrinking Economy


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10/18/2010

The market moves have been even more extreme in other corners of Wall Street. Iron ore and copper, two economically sensitive metals, have also been under heavy pressure. Gold climbs to six-year high and bond yields collapse as fears of a global slowdown mount. Bond yields collapsed on Wednesday, with the year Treasury rate briefly sinking below 1. That marks a stunning decline compared with its yield of 3.

Market Upside Down: How to Invest Profitably in a Shrinking Economy

The yield curve, a reliable recession indicator in the past, has inverted to levels unseen since The yield curve measures the gap between short-term and long-term rates. During normal times, longer maturing bonds pay out higher yields than their shorter duration peers. But that relationship has flipped upside down, alarming many investors.

Even cryptocurrencies have enjoyed the flight to safety. Although investors are clearly growing worried about a recession, that doesn't necessarily mean the economic expansion is over.

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US households are still spending and corporate America remains profitable, even if earnings are shrinking. Hedgeye's Jones agrees, predicting a "slow patch" for the US economy rather than a full-blown recession.

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Cash is no longer king as rates plunge around the world. That doesn't mean the stock market is in the clear, however, especially given the recent surge to record highs that left stocks looking expensive.


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The asset purchases shown in the chart above have been a crucial factor in supporting markets. As they have paused or reversed, so have markets. So a lacklustre summer turned into a distinctly miserable autumn and winter for equity markets. What damaged us during this period was the underperformance of high-yield bonds, returns from which can be closely correlated with equities.

Bank equities also struggled and this had a knock-on effect on their bonds. The more junior the bond; the bigger the fall. Investment-grade bonds also struggled, underperforming government bonds, with the less highly rated credits suffering the most. Through the summer, we benefited from having a 'short duration' strategy. In other words, the fund's sensitivity to interest rates was low. Our strategy was to retain our short position in government bonds using futures, which perform well when bond prices fall.

With government bond yields rising and so their prices falling through the summer this helped returns. Fortunately, we changed course during the summer, closed these short positions and took profits. This reflected our increasingly cautious outlook on the prospects for the global economy. We also decided to sell some of our riskiest high-yield bonds.

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Once again, this was profit-taking, but it also reflected our feeling that markets had run a little ahead of themselves. We had a reasonably long list of high-yield bonds on our 'sale' list, at admittedly pretty aggressive prices. Unfortunately, markets turned before some of these sell orders were executed. While this was frustrating, we chose to sit on our hands rather than selling 'at any price'.

That was not because of a lack of liquidity, but more because we were not being offered the prices we desired. Delay proved to be a sensible strategy: we subsequently witnessed a recovery after the new year, one that allowed us to continue our disposal programme at better levels. Selling these high-yield bonds generated a lot of cash. This again proved to be helpful, as the Fed revised its guidance in January. It no longer anticipates increasing interest rates another three times - but perhaps only once the market doesn't believe even one rate rise is likely. A handful of the bonds in your portfolio struggled particularly badly over the last year.

Our financial bonds came under pressure as the global interest-rate environment changed. We also own some perpetual bonds which may well be repurchased 'called' when the capital rules for banks change at the end of This is not set in stone - interpretations of the new rules differ. Only time will tell, but during the summer perceptions about the likelihood of these bonds been called changed, causing them to fall in price rather sharply.

Not all of our financial bonds were poor performers, however. We won't let pride prevent us from making money for our unitholders by holding debt issued by our competitors Bonds issued by a couple of oil-related companies - Vallourec steel tubes for oil companies and KCA offshore drilling - struggled when oil prices fell sharply at the end of Annoyingly, they haven't yet fully recovered even though oil prices have rallied.

But we are confident that they will eventually.

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Taken as a whole, the past 12 months have been somewhat frustrating. We were short of government bonds when yields were rising and moved the duration longer increased the fund's sensitivity to falling interest rates when yields were falling. We reduced the percentage of the fund invested in high-yield bonds at broadly the right time.

But we didn't shift the portfolio dramatically enough - and perhaps we didn't always move with enough conviction. To an extent, that was due to our concerns about portfolio trading costs. It also reflects our underlying view that - in the longer term - it is often sensible to ride out short-term market volatility.

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Our main focus is on the timing of the next recession. As highlighted in our interim report, we believe we are at the inflection point where owning high-yield bonds for too long could be dangerous if a recession causes defaults to increase. At the moment, not many loud alarm bells warning of imminent recession in the US are ringing. But one is: the slope of the yield curve. When the gap between yields on long-dated US Treasuries which are usually higher and short-dated yields usually lower shrinks and then inverts, we have historically seen a recession nine months or so later.


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    Market Upside Down: How to Invest Profitably in a Shrinking Economy Market Upside Down: How to Invest Profitably in a Shrinking Economy
    Market Upside Down: How to Invest Profitably in a Shrinking Economy Market Upside Down: How to Invest Profitably in a Shrinking Economy
    Market Upside Down: How to Invest Profitably in a Shrinking Economy Market Upside Down: How to Invest Profitably in a Shrinking Economy
    Market Upside Down: How to Invest Profitably in a Shrinking Economy Market Upside Down: How to Invest Profitably in a Shrinking Economy
    Market Upside Down: How to Invest Profitably in a Shrinking Economy Market Upside Down: How to Invest Profitably in a Shrinking Economy

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