3Q 2019: Observations & Outlook
Thoughts on 2019-to-date
Headed into 3Q, asset-class positioning accounted for most of the performance spread between our risk-managed strategies and their “fully invested” benchmarks. While performance numbers are still digesting the lag from our conservative positioning amid rapidly re-risking markets in 1Q especially, this quarter served to narrow some gaps and, importantly, provided space for security selection to explore momentum shifts at the sector, spread category and factor level.
The difference in 3Q was that more decisive shifts in global monetary policy affected the global interest rate dynamic such that there occurred meaningful excess return opportunity in fixed income – which our models had favored on the basis of risk-adjusted trends throughout the year – versus equity. This dynamic also pushed rate-sensitive equity sectors into the pole position globally. Macro themes were articulated clearly in some regional and sector-level performance patterns. Strength in US fixed income assets, all said, essentially filtered for headline-driven US equity noise that has been disorienting for trend-following in recent months, allowing our models’ general preference for US bonds over US equity to add value outside of intermittent downside protection.
As discussed in last quarter’s broad commentary, our models’ signals reflect a weight-of-the-evidence approach that simply struggles to outperform by jockeying around abruptly introduced or outright-new market phenomena (and we think the “Fed Put,” which in some ways has manifested as whack-a-mole, qualifies). Trend-following as a style has been challenged meaningfully by the structure of volatility and the apparent unimportance of fundamental or true macro drivers over the last 18 months. We think this point is well-illustrated by intra-month re-risking that occurred in several strategies during 2Q; these events are rare and an aspect of our adaptive momentum approach, whereby our model can reconsider, or reverse, its own near-term signals. This optionality exists so that the model can act when it recognizes that an environment is disorienting – in essence, when it recognizes its limits in the short term. In such cases the model may deploy short-term decision-making guided more by the market than by its own longer-term historical assessment. All key risk management mechanisms remain in place – the model simply recalibrates at a different pace while it works to digest the new market regime. We believe this is the difference between static quant and what we do at WST Capital Management. It also means that our models can flexibly navigate if/ as needed, should markets persist in short-term redefinitions of asset rotation and correlation behavior. Importantly, in retrospect it signals the irregularity of market pattern in the last 18 months.
As believers in our own science and the capacity of quant to add value, however, we are encouraged by signs that global markets may be positioned to support more substantial technical “arcs” than what we’ve dealt with since early 2018. US equity volatility and factor shifts aside, 3Q may have reflected the idea that key facts and trends are firm enough (in investor imagination, at least) to warrant renewed interest in fundamental and macro outlooks for certain assets. Global monetary policy direction is unambiguous and investor expectations seem rooted in a reasonable range of macro outcomes for key regions and economies. The current risk-asset run may yet have life in it given the apparent commitment of banks and policy-makers to extend the current economic cycle and revive growth through synchronized monetary easing and resolution of trade and political concern. However, we expect that markets may begin to reprice with the understanding that we find ourselves in a low-growth, low-inflation environment with well-defined monetary and economic direction. Global yields are lower today than they were mid-Crisis in 2008.
While the trade war, US political dramas, Brexit and other one-offs may drive short-term dislocations of “headline” value from fundamental value, market buying and selling going forward may reflect a hunt for value, period.
Examples might be US investors rooting out real opportunity in oversold (or underbought) value and small cap; strengthening rotation from core bonds and developed Treasuries to emerging debt, and especially local debt and currency or other sources of real “carry”; a move from longer- to shorter-duration US fixed assets given a flattening curve; interest in industries or categories that have been rag-dolled by interest rate-, commodity- or dollar sensitivity, etc. We believe factors will continue to be an interesting prism on US equity behavior (and thus broad global equity exposure) and that global sectors will afford opportunity to capture themes in the global economic journey.
The formation of a “winner and losers” environment through more conventional perspective (i.e., fundamental or macro) implies – we hope – likely expression of trading patterns that are more stable and less defiant of long-term correlation data and other inputs into trend-focused quant. The market may finally become less a function of itself and more a mirror of actual opportunity on the basis of style, sector, factor and cyclical drivers. We believe tactical can add value by preserving capital as market run-off occurs, and we believe our particular brand of active quant can help align capital with market tendencies that drive investment outcomes.
Thoughts on ETF Research, Marketplace & Liquidity
Finally, while we believe that the stage is set for the right systematic/ tactical frameworks to add more consistent value from the top down, security selection is a second and increasingly important tier of differentiation for our approach. In a beta-driven, fast-money, broad-strokes market, the effect or value of intensive ETF research efforts may be less apparent than in a market where trades “live” long enough to express differences in different types of ETFs that ostensibly do the same thing. We believe that now, more than ever, we have the opportunity to add value through our focus on understanding and selecting between flavors of input – i.e., ETFs – in our models.
We engage constantly with product providers to understand the approach to portfolio construction, from index selection or guideline definition to bottom-up security selection, quantitative tilts and the “how, when, and why” of rebalance.
The rise of ETFs has broadened the toolkit for our strategies in exciting ways; it has also created interesting problems and opportunities for tactical frameworks around those products.
In our view, the proliferation of new product may further allow us to explore what value we can add through deliberate tracking error to outsized products that are increasingly at the mercy of retail ETF flow.
To that end, we engage closely with ETF capital markets teams to understand both primary and secondary market-making, and we do not take for granted that a given security is sufficiently liquid or efficiently tradable (by our firm, our execution partners or our model recipient clients) based simply on daily volume or “normal-market” metrics. We have doubled down on our engagement of the full value chain – ETF issuers, market-makers and liquidity aggregators – in effort to be confident in our assumptions about liquidity and execution in a variety of scenarios. We consider it a pillar of our duty to our clients and we are always happy to discuss this aspect of what we do and what we have learned.
As always, we thank you for your confidence in our firm and welcome your outreach.
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