Invest like a Chameleon: Change Your Colors as the Market Environment Changes
RBA’s portfolios are sometimes included in alternative asset allocations because of our “go anywhere” macro strategy. However, we differ greatly from traditional alternative managers in that our fees are typically much lower and investors’ liquidity is on demand.
The potential for a multi-year or secular increase in market volatility has increasingly influenced our portfolio positioning. However, most asset allocators don’t realize how an extended period of financial market volatility could affect the performance of alternative assets. The environment seems to be changing, and investors need to invest like a chameleon and change their colors.
Decreasing liquidity could propel secularly higher volatility
The primary factor influencing financial market volatility is liquidity. Many investors seek to buy when a market dips, but few ever ask why investors generally don’t buy when there is a significant bear market. Of course, there are psychological factors that can impede disciplined investment processes, but that explanation overlooks that investors often simply can’t buy at the market low because they don’t have the liquidity to do so.
Chart 1 shows the relationship between the effects of Federal Reserve policy (depicted here as the slope of the yield curve) and equity market volatility. Although not a perfect relationship, there has historically been a strong link between liquidity and equity market implied volatility. The effects of monetary policy on financial market volatility can have significant lags because the Fed can’t force financial institutions to start or to stop lending.
We were very bullish 9 years ago partly because of the relationship between monetary policy and financial market volatility. Central banks around the world were desperately trying to add liquidity to the financial system in response to the global financial crisis, and we posited that US equity market volatility would be lower than was expected for a very long time because of the historically unprecedented liquidity injection.
That same relationship though is now causing us to re-evaluate our views on volatility. The gradual tightening of monetary policy has yet to work through the financial sector, but the inverted yield curve is suggesting that volatility could be on the rise.
This is not simply a US event. Chart 2 shows the proportion of global yield curves that are flat and inverted (i.e., 10-year to 2-year spread less than or equal to 100 bp). The sharp rise in this indicator suggests that global liquidity has been drying up, which implies that global financial markets are likely to become more volatile.