Asset Allocation in a distorted environment

Transcription

1 Asset Allocation in a distorted environment Optimal Investment Theory Exceptional circumstances 2

2 Abstract The current intra-emu Sovereign spreads no longer represent a pure credit differential, but they incorporate a systemic risk of EMU break-up: call it extra default risk (if after break-up weak countries were to keep their debt in ), or devaluation risk if, as we would expect, when and if countries convert their debt into the new national currency upon leaving EMU. The probability of currency split is now perceived to be non negligible. In such scenario, fundamental arguments (Unit Labor Cost trends ) argue in favor of an appreciation of the German currency against the other large EMU members by around 30%. All this means that the portion of the spread controlled by a single country is now limited: for Italy s 720bp spread in the 2Y BTP-Schatz yields reached in November 2011, only around 120bp may be considered a true credit risk (based on a regression analysis which takes into account the relative budget & debt relative fundamentals of the two countries: Italy & Germany). The other part (up to 600bp) could be ascribed to market skepticism about EMU Countries staying together in a viable way. Hence, discussing a revision of the Lisbon Treaty, a Greek exit, or any other element raising the market perception of the general EMU break-up risk puts a prevailing upward pressure on the spread irrespectively to Italy s fiscal performance. This new risk factor, however, may well trigger the infamous debtor trap (risk premiums requiring a higher budget surplus which harms growth hence solvency, which in turns means ever higher risk premiums), which is exactly what we witnessed in the past months. A circuit breaker was required to counter these systemic factors: the analysis legitimizes the ECB (only entity with sufficient b/s ammunition) restoring Financial Stability. Such circuit breaker finally arrived in the summer of 2012 with the ESM (European Stability Mechanism) complemented by the ECB s OMT (outright Monetary Transaction) a mechanism that allows the Bank to buy Bonds. Pictet Asset Management 13 November

3 EMU trasformed into a marriage of dis-interest! Fx flexibility and seignorage lost; yields at pre-emu levels: costs outweight the advantages? 10Y YTM of main EMU Countries: combination of Systemic and Country-specific patterns (for Programme Countries: Greece, Portugal, Ireland) 1,5 1,5 Source: Pictet, Bloomberg Pictet Asset Management 13 November

4 Perception on G3 Solvibility EMU pays an unwarranted premium relative to its pubic finance fundamentals 5Y CDS of the US, JAPAN and GDP weighted average od 5Y CDS of EMU (ex-greece) Countries European Commmission (Spring Forecast - May 2014) Deficit (% GDP) Debt (% GDP) years USA -9,2-6,2-5,4-4,7 102,4 104,5 105,9 105,4 Euro Area -3,7-3,0-2,5-2,3 92,7 95,0 96,0 95,4 Germany 0,1 0,0 0,0-0,1 81,0 78,4 76,0 73,6 Italy -3,0-3,0-2,6-2,2 127,0 132,6 135,2 133,9 Japan -8,7-9,0-7,4-6,2 237,3 244,0 243,7 244,1 EMU Japan USA 66bp 46bp 18bp Pictet Asset Management 13 November 2014 Source: Pictet, Bloomberg 35

5 Reasons behind EMU pain

6 The uncomfortable EMU apartment block Congenital deficiencies? Mostly market circularity and many mistakes (PSI, EBA...) In the EMU house the Greek fire started 3 years ago. The lack of windows (floating currencies) makes suffucation more likely, but does not explain why the fire spreaded so rapidly Economists (eg De Grauwe) pointed out poor Governance. Yet I believe market forces and poor decision making have been underestimated Pictet Asset Management 13 November

7 Distrust with : game changer for Sovereign Solvency Asset swaps used to measure the relative Credit Premiums: Italian case 10Y Asset Swap spread (BTP-Bund): Credit premium of BTP vs Bund = (YTM BTP 10Y ITL Swap 10Y) (YTM Bund DEM Swap 10Y) 10Y BTP-Bund 550bp 10Y Swap spread (ITL-DEM) = risk free rates in respective Currencies embed the devaluation risk of the ITL vs DEM (covered parity) Sovereign bond spreads back to pre-emu era! >400bp Asset Swap difference <150bp Pictet Asset Management 13 November 2014 Source: Bloomberg 38

8 Main reason for BTP-Bund is the Uncovered Parity With the ITL (Italian Lira), its devaluation expectations were embedded in the riskfree (swap) rate differential Today the devaluation risk is incorporated into the BTP-Bund spread The risk premium (CRP) depends on the expected probability of default: YTM BTP * (1- Pr[default]) = Risk Free Rate CRP BTP = YTM BTP Risk Free Rate = YTM BTP * (Pr[default]) The credit premium between Italy and Germany was measured as: CRP (ITA-GER) = (YTM BTP 10Y ITL Swap 10Y) (YTM Bund 10Y DEM Swap 10Y) Where Swaps enjoyed a AAA Rating (anyway the same Rating in ITL and in DEM) CRP (ITA-GER) = (YTM BTP 10Y YTM Bund 10Y) (ITL Swap 10Y DEM Swap 10Y) With reference to the Uncovered Parity: (ITL Swap 10Y DEM Swap 10Y) = E[Δ% (ITL/DEM)] Hence: CRP = (YTM BTP 10Y YTM Bund 10Y) E[Δ% (ITL/DEM)] Which leads to: (YTM BTP 10Y YTM Bund 10Y) = CRP (ITA-GER) + E[Δ% (ITA/GER)] * Pr[ breakup] Pr[ break-up] could be interpreted as a CONVERSION RISK in case of EMU break-up or DEFAULT following the NON-CONVERSION in case of Italy exiting EMU (the latter ought to be reflected into CDS spreads, while not the former as CDS do not trigger if a G7 Country changes legal tender (and its securities are reinbursed in such cncy). Pictet Asset Management 13 November

9 BTP-Bund definitely includes EMU Reversibility Risk 10Y BTP-Bund Spread = Credit Premium + Expected Realignment x Probability of Fluctuation 12 Oct 14 YTM 10Y BTP YTM Bund 2,33% 0,83% Spread 10Y BTP vs Bund 150bp Pictet Asset Management 13 November 2014 Source: Pictet, Bloomberg 40

10 The Credit Premium 10Y BTP-Bund Spread = Credit Premium + Expected Realignment x Probability of Fluctuation 12 Oct bp = 160 bp 2,5 Actual 500bp 2,0 1,5 1,0 Fitted Estimates Δ ASW (2Y of IT-DE) 2Y = BTP-Schatz 10Y BTP-Bund Credit C + component Δ Debt/GDP (IT-DE) spread spread Pictet + Δ [GDP growth IT 121 Avg bp Debt Servicing 160 bp IT] Bank + Δ of Primary Italy Surplus (IT-DE) bp ca. 200 bp 120bp 0,5 0,0-0, Regression shown refers to the 2 year case R2= 0, Source: Pictet Pictet Asset Management 13 November

11 The Expected Realignment in case of currency divorce 10Y BTP-Bund Spread = Credit Premium + Expected Realignment x Probability of Fluctuation 12 Oct bp = 160 bp + 30% EMU Inception Spain Italy France 30% Unit Labour Cost USA Germany Pictet Asset Management 13 November 2014 Source: OECD, Bloomberg 42

12 Probability of Flotation 10Y BTP-Bund Spread = Credit Premium + Expected Realignment x Probability of Fluctuation 12 Oct bp = 160 bp + 30% x 0% Assumptions (see previous slides): Expected depreciation of new ITL/DEM in case of currency exodus: 30% Credit premium: 120bp Based on 2Y Yield to maturity (BTP, Schatz, swaps) 36% 24% Today: OMT (GCC a hurdle?) Medium term: barring ERF or Eurobonds, Realignment Risk should be contained via converging fundamentals. Or new Crises? 2% Source: Pictet, Bloomberg Pictet Asset Management 13 November

13 Ab-Normal Correlation regime (short run) Equity - Bonds Equities Bonds Growth, Inflation prospects improve Growth, Inflation prospects deteriorate Sales, Earnings rise, Price rise Sales, Earnings fall, Price fall Yields rise, Price fall Yields fall, Price rise Negative Correlation Equities-Bonds EMU Crisis worsens Sales, Earnings rise, Price fall Peripheral Yields rise, Price fall Positive Correlation Equities-Bonds Pictet Asset Management 13 November

14 EMU Therapy

15 After 26 July, everything changes Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London 26 July 2012 Mario Draghi, President of the ECB, Vítor Constâncio, Vice- President of the ECB, Frankfurt am Main, 2 August 2012 [ ] Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough [ ] Then there s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to do, as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty - they come into our mandate. They come within our remit. [ ] The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible. [ ] Pictet Asset Management 13 November

16 Outright Monetary Transactions (OMT): the «circuit breaker» Positives The ECB kept its promise to do whatever it takes : it falls within the ECB duties to repair distorted sovereign spreads as well as financial fragmentation among EMU countries Proposed purchases : government bonds with 1-3years residual maturity. Good compromise Unlimited amount may by bought by the ECB The BCE explicitly gives up privileged creditor status on bonds purchased under OMT (NB: not under previous SMP!) this increases the residual value of bonds for private investors Trasparency as for: amounts purchased, its market value, etc. the German government confirms: the BCE is operating within its mandate Bundesbank only dissent Negatives Stricter and effective conditionality. Activation of OMT will depend on acceptance by Spain or Italy (if any) of IMF supervision. High domestic political cost Bundesbank s opposition still there (would weigh on activation) Sterilisation of purchases under OMT in order to immunise monetary impacts (no QE) Pictet Asset Management 13 November

17 Draghi shot the «black swan» of EMU break-up Pictet Asset Management 13 November

18 EMU Exit Strategy ROADMAP (June 12) 1. Banking Union: supervision & resolution, limited guarantee on bank deposits (2013) 2. Fiscal Union: SGP-F. Compact (Str.Def.<0,5%; Debt/GDP->60%, 5%/yr; Procedure) 3. Political Union: by 2020? TECHNICAL DECISIONS-ECB LTRO (Dec 11-Feb 12); Repo rate cut (Jul 12). Likely again very soon (depo?) OMT (Sep 12): BCE -> financial stability (conditional to PCCL/MoU with ESM) Other Measures aimed at reducing Financial Fragmentation and Credit Crunch END-GAME for EMU Necessary conditions Necessary and (temporarily) sufficient conditions Full Political Union: Risk pooling (Eurobonds, ERF) once Economic and Fiscal Convergence is achieved (2015?). This process requires pooling Sovereignty EMU Break-up: OMT fails, crisis, default, divergence? POLITICAL DECISIONS POLITICAL DECISIONS Sufficient conditions Exp. Realignment Probability of Fluctuation Credit Premium Pictet Asset Management 13 November

19 EMU must progress on the RODMAP or... troubles ahead Unless EMU integrates, tension re Austerity and/or ECB is likely (eventually leading to German Exit?) Current Situation EMU Disintegration (<10%) Monetary Union Fiscal Autonomy EMU Integration (>90%) Traumatic Event Gradual Process BCE, ESM FMI etc.: Bridge Financing a reinforced EMU structure National Currencies One Country leaves (Greece or Germany?) No eurobond Weak Central Budget Authority Eurobonds Strong Central budget Authority Increasing number of new-national Currencies Growing Fiscal Federalism Source: Pictet Pictet Asset Management 13 November

20 Correlations between bonds and equities, Germany, Italy The core bonds (USA e Ger) negatively correlated with equities. This DOES NOT apply to Italy! CORRELATION between GERMAN BUNDS and MSCI EMU CORRELATION between ITALIAN BTP and MSCI EMU 70% 50% 30% Average 10% Average -10% -30% -50% Correlazione -70% gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 Pictet Asset Management 13 November 2014 Source: Pictet, Bloomberg 51

21 Asset Allocation in a distorted environment Optimal Investment Theory Exceptional circumstances How to adapt

22 Expected volatilty Uncertainty reduced by endogenous Fed (unemployment doesn t decrease, QE increses) and BCE s OMT Implied Volatility (Index Options) Source: Pictet, Bloomberg Pictet Asset Management 13 November

23 Correlation among different Asset Classes MSCI World MSCI World MSCI USA MSCI EMU MSCI EM MSCI Japan Hedge HFRX EM Debt HC /$ / Commodities GOLD EM Debt LC Corporate Gov Bonds Inflation L MSCI World MSCI World MSCI USA MSCI EMU MSCI EM Hedge HFRX MSCI Japan Commodities EM Debt HC Corporate Inflation L EM Debt LC /$ Gov Bonds GOLD / Source: Bloomberg Pictet Asset Management 13 November

24 Correlation Analysis If correlation falls (better if <0) when volatility rises, then the diversification benefit intensifies Volatility and Correlation (weekly; 12M rolling) 40% 35% 30% 25% 20% Volatility and Correlation (weekly; 12M rolling) Annualised Vol Equity Volatility (St. Dev.) Bond Volatility (St. Dev.) Correlation (rhs) 0,20 0,10 0,00-0,10-0,20-0,30 15% 10% 5% 0% gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 gen-14-0,40-0,50-0,60-0,70-0,80 Avg: -0,42 Source: Pictet, Bloomberg Pictet Asset Management 13 November

25 Correlations between bonds and equities, USA & Italy (Jan 13) The core bonds (USA e Ger) negatively correlated with equities. This DOES NOT apply to Italy! CORRELATION BETWEEN US TREASURIES and MSCI W ($) CORRELATION BETWEEN ITALIAN BTP and MSCI EMU 0% 70% -10% 50% -20% -30% 30% Media -40% QE1 Media 10% -50% -60% QE2-10% -30% -70% Correlazione QE3-50% Correlazione -80% gen-08 gen-09 gen-10 gen-11 gen-12 gen-13-70% gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 Source: Pictet, Bloomberg Pictet Asset Management 13 November

26 Correlations between bonds and equities, USA & Italy (now) The core bonds (USA e Ger) negatively correlated with equities. This DOES NOT apply to Italy! CORRELATION BETWEEN US TREASURIES and MSCI W ($) CORRELATION BETWEEN ITALIAN BTP and MSCI EMU 80% 20% 60% 0% 40% Avrg. -20% 20% -40% QE1 Avrg. 0% -60% Correlation QE2 QE3-20% -40% Correlation -80% gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 gen-14-60% gen-08 gen-09 gen-10 gen-11 gen-12 gen-13 gen-14 Source: Pictet, Bloomberg Pictet Asset Management 13 November

27 Sick Correlations: the collateral damage of the financial crisis In the last 12 monthes, few defenses CORRELATION BETWEEN MSCI EUROPE AND OTHER FINANCIAL ACTIVITIES S&P500 MSCI EM Treasury Bund Govies 4/2011-4/2012 (d) Oil Gold USD JPY -0,8-0,6-0,4-0,2 0 0,2 0,4 0,6 0,8 1 Source: Bloomberg Pictet Asset Management 13 November

28 Different portfolios optimization methodologies (continued) We introduce now two different kind of portfolio optimizations, the Maximum Diversification and the Risk Parity approaches, which focuse on risk allocation, usually defined as volatility, rather than allocation of capital or returns (they are also known as risk-based approached). Maximum Diversification Portfolio The Maximum Diversification portfolio maximizes the ratio of weighted-average asset volatilities to portfolio volatility w σ max w Ωw Risk Parity Portfolio In the Risk Parity Portfolio the weights must be chosen such that the contribution of each asset to the portfolio risk is equal. This requirement can be approximated by the constraint 2 2 δσ P δσ P w i = w δw j i δw j i, j 1,.., n Source: Clarke, De Silva, Thorley (2012); Daly, Rossi and Herzog (2012) Pictet Asset Management 13 November

29 Portfolio exercise: max diversification 2010 Repeated crises challenged Markowitz, Relative Value strategies (HF) due to sick correlations WHICH PORTFOLIO? In normal times: Markowitz and optimal PTF (max Sharpe Ratio) Equally weighted portfolio, balanced portfolio and risk parity portfolio performances With volatility but stable negative correlation: balanced PTF With volatility and uncertain correlations: equally weighted PTF (max diversification) With volatility and changing correlations: risk parity based PTF (close to minimum risk) After the 2008, the risk parity PTF if the best performing one! Source: Bloomberg MSCI World etc. Pictet Asset Management 13 November

30 Conclusions The benefits coming from diversification are directly proportional to the degree of decorrelation among the investment portfolio s assets. Since the subprime crisis of 2008, correlations remained relatively high (typical during financial turmoils). On the contrary, the volatilities have experienced a normalization. One of the causes of the correlations behaviour is the standardization of the investors behaviour, affecting in particular intra-assets correlations. The correlation between equities and bonds has been affected by the European Debt Crisis and by the behaviour of the Fed in the USA, and later many other Central Banks adopting Quantitative Easing, that favour (at least a temporary) inversion of the correlation sign from negative to positive. When there is uncertainty on the economic growth, the correlation between equities and bonds should be normal (negative): this could encourage holding a longer duration. Because of the paucity of decorrelations, there are now less opportunities than before. How to face this new world? Two solutions: i) Reduce your Total Return objectives; ii) become more «aggressive» in order to reach sub-optimal but higher gains. Either way, we are induced to diversify through additional presence of risky assets (equities). In this last case, using a max Diversification portfolio (or based on Risk Parity), instead of a max Sharpe one, may hold better in the face of uncertain/unstable correlations. Pictet Asset Management 13 November

31 Flexible approach to compensate for lower ex-ante Returns Risk and Return assumptions resulting from the Asset classes included in our Flexible Portfolio - Jan 13 TER Source: Pictet, Bloomberg Pictet Asset Management 13 November

32 Managing risk: keep ex-ante volatility under control (8% Max) Growth Outlook Extreme + Secular Outlook Ex Ante Volatility TAA Extreme - Time Equity Exposure Pictet Asset Management 13 November

33 Ex-Ante Volatility of Pictet Multi Asset Global Opportunities Risk Management in Portfolio Construction Volatility Budget Asset Class Contribution to Volatility (bp) Bonds 102 Cash 0 Equities 343 Unclassified -12 TOTAL 433 Source: Pictet, Bloomberg Pictet Asset Management 13 November

34 Performance of Pictet Multi Asset Global Opportunities Performance and Volatility of MAGO and its reference MSCI World MAGO (I) Eur Bonds 3-5 years Realized Volatility (240dd): MAGO: 3,3 MSCI World: 8,9 Eur Bonds 3-5 anni: 1,4 Source: Pictet, Bloomberg Pictet Asset Management 13 November

35 Hope you received some hints good luck for your financial DIY! Andrea Delitala Investment Advisory Milano, 8 Aprile 2014

36 References Berry R. Value-at-Risk: An Overview of Analytical VaR. Available at Clarke R., De Silva H. and Thorley S. (2012). Risk Parity, Maximum Diversification, and Minimum Variance: An Analytic Perspective. Journal of Portfolio Management, Forthcoming. Daly D., Rossi S. and Herzog F. (2012). Methodology for the Construction and Enhancement of Risk-Parity Portfolios. SwissQuant Group AG, Zurich, Switzerland: Duffie D. and Pan J. (1997). An Overview of Value at Risk. The Journal of Derivatives, Spring 1997, Vol. 4, No. 3: Pictet Asset Management 13 November

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