Blog

Author: Tim Sharp

Researcher: Jack Williams

Published: June 1, 2023

After Turkish President Tayyip Erdogan’s re-election, Turkey’s financial markets once again experienced turbulence, as the Turkish Lira reached an all-time low against the US dollar, and the country’s sovereign bonds depreciated in value. Erdogan, who has been in office since August 2014, secured another five-year term, defeating opposition leader Kemal Kilicdaroglu, a Turkish economist, retired civil servant, and social democratic politician who was widely regarded as someone capable of addressing the problems that have arisen during Erdogan’s tenure. Since 2016, Turkey has faced strained relations with most European nations, a decline in media freedom, and, most significantly, an increase in the money supply during periods of high inflation, leading to further inflationary pressures.

Figure 1 – Turkish Inflation Rate (Statista)

 

Remarkably, Turkey’s inflation rate over the past 12 months has surpassed a 24-year high, soaring to over 85%. These price surges can be attributed to Erdogan’s unorthodox monetary policy, which contradicts the approach taken by other central banks and countries during this period of high inflation. Rather than raising interest rates, as most would expect, Erdogan has pursued a strategy of lowering rates, resulting in spiralling inflation that has negatively impacted the population. Unsurprisingly, this issue featured prominently in the election campaigns of both major parties in the recent election.

Investors have expressed concerns about this matter and have contemplated whether Erdogan might consider revising his monetary policy to restore financial prudence in the country. In recent weeks, an internal party team has hinted at the possibility of such a policy shift.

This renewed enthusiasm has sparked a rally in Turkish equities, particularly in the banking sector. Notably, the broader Turkish Index (BIST) has surged by 11.84%, while the banking-focused Turkish BIST BANKA index has experienced a remarkable rally of 14.94% in the past five trading days alone. Although Turkish Credit Default Swaps (CDS) have only marginally retreated from their elevated levels, decreasing from 624 to 622, the cost to insure against defaults has significantly risen since the beginning of the year. CDS swaps started the year at a rate of 513, representing an increase of 21.2% to their current levels.

Figure 2 – Turkish BIST Index (RefinitivData)

 

Figure 3 – Turkish BIST BANKA Index (RefinitvData)

Turkish investors undoubtedly hope for further declines in CDS rates as Erdogan announces his new cabinet, in the expectation that some positions will be filled by candidates who favour a more open-market approach. This would pave the way for the necessary changes to Turkey’s detrimental monetary policy, which both the country and international investors aspire to witness. Presently, Turkish 10-year bonds offer a yield of 9.705% and have performed poorly compared to other emerging market (EM) debt instruments, with a decline of -5.8% as opposed to the -1.6% decrease observed in the broader EM dollar bond space.

Figure 4 – Turkey CDS (WorldGovBond)

 

 

Sources:

 

Al Arabiya English. (2023). Turkey sovereign dollar bonds rise as markets await Erdogan’s economic team. [online] Available at: https://english.alarabiya.net/business/economy/2023/05/30/Turkey-sovereign-dollar-bonds-rise-as-markets-await-Erdogan-s-economic-team [Accessed 31 May 2023].

Karakaya, K. (2023). Turkish Lira Sinks, Stocks Gain as Investors Bet on Policy Shift. Bloomberg.com. [online] 30 May. Available at: https://www.bloomberg.com/news/articles/2023-05-30/turkish-lira-sinks-stocks-gain-as-investors-bet-on-policy-shift.

Parsons, A. (2023). As Kilicdaroglu takes on Erdogan – here’s why Turkey’s election may well be the most important in the world this year. [online] Sky News. Available at: https://news.sky.com/story/as-kilicdaroglu-takes-on-erdogan-heres-why-turkeys-election-may-well-be-the-most-important-in-the-world-this-year-12879032.

Statista. (n.d.). Turkey monthly inflation rate 2022. [online] Available at: https://www.statista.com/statistics/895080/turkey-inflation-rate/.

TradingEconomics (n.d.). Turkey Government Bond 10y – 2022 Data – 2010-2021 Historical – 2023 Forecast – Quote. [online] tradingeconomics.com. Available at: https://tradingeconomics.com/turkey/government-bond-yield.

Charts/Data – RefinitivData / Hottinger Investment Management / YCharts

Author: Tim Sharp

Researcher: Jack Williams

Published: May 25, 2023

The 2011 debt ceiling issue was a significant event that unfolded in the United States, casting a shadow of uncertainty over the country’s financial stability. The dispute, primarily between the Obama administration and the Republican-controlled Congress, revolved around raising the federal debt ceiling to avoid defaulting on the nation’s financial obligations.

The debt ceiling is a statutory limit set by the US Congress on the amount of national debt the government can accumulate, which has been a major story in recent weeks as the US default probability rises, and the country nears their resolution deadline.

In 2011, the United States approached its debt ceiling of $14.3 trillion, leading to a heated political debate. Republicans demanded significant spending cuts and fiscal reforms in exchange for raising the ceiling, while the Obama administration argued for a “clean” increase without any attached conditions.

As we near the 2023 ‘X’ date of the 15^th of June 23’ (the date interest payments on U.S debt are scheduled to be made, many institutions such as J.P Morgan, rather than looking forwards are looking backwards to 2011 to gain an idea of how the market might react should the U.S not come to a resolution in time.

Whilst many of the same names (JPM etc.) are cautiously optimistic that discussions between Biden and speaker McCarthy will produce at least a partial deal to either raise or suspend the debt ceiling, as we near the ‘X date’ the risk of default rises dramatically.

The chart below shows the probability of the U.S defaulting, and how the risk of default grows as the ‘X date’ nears. The blue line below shows the probability of default in 2011, as the U.S neared their X date a sharp uptick in risk of default appeared, rising to almost 6%.

The partial grey line follows the risk of a U.S default this year (2023) which has seen a sharp rise recently, similar to moves seen in 2011.

 

Figure 1 – J.P. Morgan Equity Macro Research, Bloomberg Finance L.P

 

 

Figure 2 – Bloomberg Data

 

Figure 2 below shows short term 1-month T-Bill yields, which as of recent have spiked, suggesting increasing default concerns, a stark contrast to the rallies seen amidst US indices in recent weeks.

In times such as these where volatility is expected, one might expect to see flows into treasuries as investors look to take some risk off the table, however T-Bill have surprisingly traded in the opposite direction, now trading at yields in excess of those seen amidst the 08’ financial crisis.

In 2011, prolonged and contentious negotiations over the debt ceiling caused uncertainty to flood into financial markets, particularly within the U.S as investors worries about the prospect of a default. This led to increased volatility and heightened risk which lasted for nearly three trading months.

In the weeks leading up to the 2011 August 2^nd deadline the market experienced significant swings. Throughout July 11’ all major US indices (DJIA, US500 and Nasdaq) witnessed substantial declines. The DJIA for example saw several days of triple digit losses, with the index shedding over two thousand points through a two-week period.

 

Figure 3 – J.P. Morgan / Bloomberg

 

During this time, the US 500 index declined by 17% with the brunt of the beating being felt by materials, financials, and energy, while defensive strategies excluding real estate outperformed.

Furthermore, to amplify market turmoil, ratings agency Standard and Poor’s downgraded the US sovereign credit rating from AAA to AA+, marking the first time in history the U.S lost its top tier credit rating.

Figure 4 – SP500 (2011) TradingView

While there are clear differences between the 2011 debt debacle and the current issue, perhaps the largest being the Rate of Inflation and Fed Funds Rate (both of which were dramatically lower in 2011 than today) many lessons have been learned regarding why negotiations must be conducted and concluded swiftly. That being said, one cannot ignore the risk however small of a US default and its potential impact on markets.

Figure 5 – Bloomberg Data

 

The U.S president Joe Biden has cancelled a planned visit to Australia and Papua New Guinea to focus on debt limit talks, with speaker McCarthy commenting that talks were productive in nature. It is true that the US has never defaulted on its payments before and the debt ceiling has been raised 78 times since 1960 under both republican and democrat presidents, although ex-president Trump is calling for a default as his preferred resolution.

On 26^th April Republicans passed a bill in the house that would raise the debt ceiling by $1.5Tr but mandated $4.8Tr in spending cuts over a decade, although democrats have so far refused to negotiate spending cuts over the debt ceiling talks.

Negotiations are expected to resume Wednesday 24^th with Republicans looking for some kind of guarantee on spending/budget caps and investors hoping for news regarding some sort of resolution.

 

 

Sources:

 

Asset Management , J.P.M. (2023). How Does the Debt Ceiling Progress From Here? | J.P. Morgan. [online] www.jpmorgan.com. Available at: https://www.jpmorgan.com/wealth-management/wealth-partners/insights/how-does-the-debt-ceiling-progress-from-here#:~:text=With%201Y%20CDS%20at%20a.

Authers, J. (2023). On X+1 Day, We Won’t Be Going Back to Normal. com. [online] 24 May. Available at: https://www.bloomberg.com/opinion/articles/2023-05-24/debt-deal-before-x-1-day-the-us-crisis-will-have-already-begun?leadSource=uverify%20wall.

Aratani, L. (2023). What is the US debt ceiling and what will happen if it is not raised? The Guardian. [online] 17 May. Available at: http://www.theguardian.com/business/2023/may/16/what-is-debt-ceiling-limit-explainer.

BGR Group (2021). History of Debt Limit and Why It Matters | BGR Group. [online] BGR Group. Available at: https://bgrdc.com/history-of-debt-limit-and-why-it-matters/.

Palumbo, A. (2023). Stock Market Today: Dow Drops, Premarket Movers, Debt Ceiling Talks, Fed Minutes, Bitcoin Falls, Nvidia Earnings, China Covid-19. [online] www.barrons.com. Available at: https://www.barrons.com/livecoverage/stock-market-today-052423?mod=article_inline.

P. Morgan (n.d.). Debt ceiling drama: What you need to know. [online] www.jpmorgan.com. Available at: https://www.jpmorgan.com/wealth-management/wealth-partners/insights/debt-ceiling-drama-what-you-need-to-know#:~:text=Today%2C%20that%20limit%20stands%20at.

Author: Tim Sharp

Researcher: Jack Williams

Published: May 18, 2023

 

In this week’s Chart of the Week, we examine the recent performance disparity between copper and gold, two key commodities, within the context of the current global economic environment. While the overall Goldman Sachs Commodity Index (GSCI) has experienced losses of approximately 30% over the past year, certain commodities within the index have demonstrated strong returns, fuelled by the prevailing high inflation and uncertainty. This study aims to elucidate the drivers behind the contrasting performance of copper and gold by delving into the factors that influence their respective prices.

Copper’s Underperformance

Despite the positive economic growth forecasts, particularly those for China, which exceed 5% in terms of economic expansion, copper’s performance has surprised many investors. Given copper’s extensive use in construction, electrical equipment, wiring, and manufacturing, its price movements are closely tied to global economic growth and investor sentiment. However, the present climate of heightened global uncertainty surrounding economic growth in the US, Eurozone, and UK does not bode well for copper. As a result, the anticipated rise in copper usage, which would tip the supply/demand balance in favour of investors, has not materialized. Consequently, copper has lagged gold in terms of returns.

Copper vs. Gold: The Role of Cyclical Stocks

The performance of copper and gold is intricately linked to cyclical stocks, exhibiting a correlation of 76%. Cyclical industries, such as manufacturing, construction, automotive, heavy machinery, and infrastructure development, are heavily influenced by the overall economic cycle. During periods of economic prosperity, these industries thrive, while economic downturns pose challenges for them. Copper, being closely associated with economic growth, is often used as a leading indicator of economic health. An increase in copper prices and demand signals optimism regarding future economic growth. Conversely, gold’s performance is driven by factors such as central bank policies, inflation and currency fluctuations (particularly in the context of a weak dollar), economic and political instability, and investor sentiment.

 

Gold’s Strengths

Gold, traditionally regarded as an inflation and war hedge amongst investors, has regained its appeal as such due to recent developments. Central banks, grappling with historically high and persistently sticky inflation, have raised interest rates to curb rising prices. Additionally, ongoing geopolitical tensions, including the war in Ukraine, escalating China-Taiwan tensions, and deteriorating relations with Western nations, have heightened economic and political instability to levels not witnessed in recent times. These factors have significantly favoured gold investors, as the precious metal is perceived as a ‘safe haven’ in times of uncertainty.

 

Summary

In brief conclusion, the substantial underperformance of copper compared to gold can be attributed to the global economic climate and the nature of the commodities themselves. Copper’s price movements are closely tied to economic growth and investor sentiment, making it susceptible to the prevailing uncertainties. On the other hand, gold’s performance is driven by a range of factors, including central bank policies, inflation, geopolitical tensions, and investor sentiment. Given the present economic landscape characterized by uncertainty, high inflation, and geopolitical risks, gold has outperformed copper and lived up to its status as an inflation and war hedge, at least for the time being. These findings highlight the importance of analysing the drivers behind commodity price movements and considering the broader economic and geopolitical context when making investment decisions.

 

 

 

 

Sources:

S&P GSCI Total Return Performance & Stats (ycharts.com)

https://ycharts.com/indicators/gold_price_london

RefinitvData/Hottinger (ABRDN Physical Gold x WisdomTree Copper x Wisdomtree Silver x Crude Spot Price)

RefinitivData/Hottinger Gold Spot Price – 5yr

 

S&P GSCI Total Return Performance & Stats (ycharts.com)

https://www.bullionbypost.co.uk/price-ratio/gold/silver/10year/

https://www.xe.com/currencyconverter/convert/?Amount=1&From=USD&To=GBP

LME Copper | London Metal Exchange

Author: Tim Sharp

Researcher: Jack Williams

Published: May 16, 2023

As anxiety spreads among investors, the cost of insuring against a possible U.S. credit default has surged to its highest level in more than ten years, surpassing levels observed in early 2009. This surge is a result of the United States coming closer to the brink of a potential default or breach of its debt ceiling.

Shown on the below chart, the United States has reached the level of its debt ceiling following a rapid rise in borrowing from 2017, partially worsened by the pandemic and knock on measures the country had to take to keep the economy alive such as their mass Stimulus Payments scheme.

Yesterday, US Sovereign CDS (Credit Default Swaps) rose again to 74 basis points according to Bloomberg Global Market Data, up from 73 points on the previous day’s close (+1.34%), and the highest level traded since March 2009.

A credit default occurs when a borrower is unable to meet its debt obligations, causing a default on its loans. In the case of the United States, a default would mean that the country would be unable to repay its debt, which would have severe consequences for the global financial system. Given that the United States is one of the largest borrowers in the world, a default could potentially trigger a major crisis, and could even lead to a sharp increase in borrowing costs, and a potential drop in the value of the U.S. dollar.

In order to protect themselves from the risks of a potential default, investors buy credit default swaps (CDS), which are financial instruments that act like insurance policies against default. A CDS pays out in the event of a default, providing investors with compensation for the losses they may incur.

The surge in the cost of CDS indicates that investors are becoming increasingly worried about the United States’ ability to meet its debt obligations. The cost of insuring against a potential default has risen significantly, suggesting that investors believe that the likelihood of a default is increasing, however it is worth noting that the overall probability of a US default is less than 6% over the next 5 years.

Substantial evidence of market stress linked to the tensions surrounding the debt ceiling have already begun to appear. Such has been seen recently by the significant increase in yields on Treasury bills that are set to mature around the X-date (Potential Default Date), resulting in higher borrowing costs for the government and consequently, for taxpayers as well. Figure 2, depicted below, clearly shows this trend. Since mid-April, there has been a near 1 percentage point increase in yields on short-term Treasury bills, which is nearly a 20% move from where yields previously stood. US Treasury Secretary Janet Yellen has been trying to raise the alarm, she says the potential default could happen as soon as June 1^st.

When asked to speak to the potential outcomes of a default on US debt, the White House points to the written piece on their default which includes a study on the risks of a protracted default. A simulation ran by the CEA showed an immediate, sharp recession to the magnitude not seen since the great recession (2007-2009). In 2023 Q3, the first full quarter following the simulated debt ceiling breach, the simulation showed a 45% drawdown in the stock market, while consumer and business confidence takes a substantial hit. Unemployment was modelled to increase by 5 percentage points as consumption cuts take place.

Moody’s recently undertook a similar study using their own model, which predicted under a clean debt ceiling breach job growth continues northbound adding 900,000 jobs. Although under a protracted default situation, the modelled job losses amount to almost 8 million, which would be even further unemployment than The White House is forecasting within their own.

 

 

 

 

https://www.whitehouse.gov/wp-content/uploads/2023/05/DL-Figure-1.3.png

https://www.whitehouse.gov/wp-content/uploads/2023/05/Debt-Limit-Blog_Figure2.png

 

Figure 1 – https://www.crfb.org/papers/qa-everything-you-should-know-about-debt-ceiling

Figure 2 – https://www.whitehouse.gov/cea/written-materials/2023/05/03/debt-ceiling-scenarios/#_ftn1

Figure 3 – https://www.whitehouse.gov/wp-content/uploads/2023/05/DL-Figure-1.3.png

Figure 4 – https://www.whitehouse.gov/wp-content/uploads/2023/05/Debt-Limit-Blog_Figure3.gif

Datapoints/charting – Bloomberg Global Market Data / Refintiv Data

 

Author: Tim Sharp

Researcher: Jack Williams

Published: April 27, 2023

Demand for the mineral and the products it can produce has arguably never been higher, however the raw spot price of Lithium Carbonate, the preferred form of lithium for uses such as EV Batteries and grid storage has plummeted in recent months, losing nearly two thirds of its value.

As the global energy landscape evolves and the demand for renewable energy solutions and electric vehicles increases, Lithium has emerged as a key part of the energy transition towards sustainability. Amongst its forms, Lithium with its high energy density has gained significant attention in recent years as an opportunity for investors wishing to play the green transition within their portfolios. Lithium Carbonate, the lithium form of choice for EV battery builders and energy storage systems due to its purity and being amongst the highest of energy densities within the metals, has been watched closely in recent months as prices retreat from it’s all time high of 597,500 CNY/Tonne to below 175,000 CNY.

Recently Bloomberg released a study forecasting the Global Lithium Supply and Demand through to 2030, in which they predicted Lithium Demand to more than triple by the end of the decade with government programmes phasing out the production of traditional ICE (Internal Combustion Engine) based cars and transport, along with an increased prioritisation towards the storage of the energy generated from renewable sources such as wind farms that has been seen in recent years. Other bullish drivers considered within the Bloomberg study included enhanced customer adoption and interest around lithium-based transport, increased milage/battery pack sizes, increased lithium content in chemistries and real-world energy cell densities increasing. All of which would be positive for lithium in the longer term, or one would think so.

For Lithium investors, recent months have been disheartening to say the least, while EV bulls have rejoiced at the prospect of the lower costings for the most expensive part of the car to produce going forward. For Longer range EV’s, as much as $20,000 or £16,099 of the price tag of an EV comes from the cost of the battery.

Many investors are wondering with such a strong long-term story, why has Lithium has been hit so hard in recent months?

On the demand side, this can be explained by a less bullish sentiment around EV’s in China as a decade long EV subsidy programme winds down in addition to the extended Lunar New Year celebrations which eroded the sales of new cars at the turn of the year.

Lithium Analysts such as Fastmarket’s Jordan Roberts side with the theory of markets waiting to see the impact from lower consumer subsidies and consumer confidence data, which is currently tied to the country’s property crisis. By subsidising EV’s to price parity with conventional ICE cars, the country experienced a huge swathe of growth in its EV market, most recently at a rate of 90% in 2022. Dutch ING Groep formed a similar thesis in late February when they said “the fiscal burden has risen, and the government may not want to spend on subsidies to boost consumption when the economy is recovering. After the fiscal driven spike over the past few years, EV sales will slow.”

In Mid-February, the worlds largest Lithium-Ion battery manufacturer CATL (Contemporary Amperex Technology Co., Limited) had started offering discounts on batteries sold to Chinese EV companies such as Nio and Xpeng showing the downturn in spot prices for the essential minerals involved in battery production. CATL held around 37% market share globally for EV makers.

While demand for lithium is somewhat impacted, many point to the supply side of lithium as being the main contributor to falling prices this year. Production and exploration of Lithium have increased over recent years, with miners motivated by high spot prices and limited supply levels, however this according to many institutions could be set to change as waves of fresh supply come online from facilities in China, Australia and Chile. Bank of America, JP Morgan and Morgan Stanley all forecast production increases of between 22% and 42% in 2023 alone. New supply is coming online at a roaring pace, while demand appears to remain relatively strong given its long-term prospects, supply surges and downstream overcapacity could bring lithium prices down further in the medium term.

Recent announcements in March have continued to drive down lithium prices as supply is unveiled in more jurisdictions globally, such as the first lithium deposit to be discovered in Iran’s mountain province of Hamedan, believing to hold over 9 million tonnes of lithium, equitable to around 10% of the world’s total proven deposits.  Discoveries of this size cause investors to reassess the total amount of lithium out in the world, and the price they are willing to pay for it. Scarcity drives prices, while abundances drive prices down in the same way as seen most other metals and commodities.

The question in many investors are pondering is with such a structural change emerging with Lithium and it’s strong future prospects, will these pockets of uncovered supply really put a dampening on the long term spot price or has the negativity amongst investors perhaps been overdone, with more use cases coming forward, can the scales of supply and demand equalise once again for Lithium as EV’s, Battery Storage and green energy increase in popularity and availability.

 

 

Sources:

https://internationalbanker.com/brokerage/why-are-lithium-prices-collapsing/

https://www.globalxetfs.com/funds/lit/#performance

https://www.wsj.com/articles/lithium-prices-are-down-cheaper-batteries-and-evs-could-follow-7a171fc0

https://internationalbanker.com/brokerage/why-are-lithium-prices-collapsing/

https://about.bnef.com/blog/will-the-real-lithium-demand-please-stand-up-challenging-the-1mt-by-2025-orthodoxy/

https://www.mining.com/web/lithium-in-china-may-be-bottoming-as-low-margins-hit-producers/

https://www.prnewswire.co.uk/news-releases/lithium-gold-rush-continues-as-demand-skyrockets-for-electric-vehicles-and-renewable-energy-301804482.html

https://www.fastmarkets.com/insights/lithium-supply-and-demand-to-2030

 

Chart 1: https://uk.investing.com/commodities/lithium-carbonate-99.5-min-china-futures-historical-data

Chart 2: Bloomberg NEF, Avicenne Global Lithium Supply & Demand Forecast Study (Bloomberg NEF)

Chart 3: Global X ($LIT) Lithium & Battery Tech ETF

By Alan Dunne, Archive Capital

 

2022 may prove to be a watershed year in markets, not just because it was the worst year in decades for fixed income. It was the year that demonstrated the limitations of the 60-40 model. The experience of seeing bonds and equities decline concurrently encouraged many investors to seek a more diversified asset allocation model with higher allocations to alternatives[i].

 

The Shifting Macro Landscape

A key reason for now considering alternative investments is the changed macro backdrop. Not only have we witnessed the highest level of inflation in decades and the fastest adjustment in US interest rates, COVID-19 and rising geopolitical tensions have raised the possibility of deglobalization and a realignment of global trade.

These shifts in geopolitics and capital market trends and in demographics, technology and resource utilisation, have prompted McKinsey to suggest that the global economy may be on the cusp of a New Era[ii], replacing what they call the Era of Markets of the last 40 years.

From an economic perspective the transition has been from a demand-constrained economy with disinflationary tailwinds to a supply-constrained economy with inflationary headwinds. That points to less palatable policy trade-offs for central bankers going forward and the potential for a new era of Great Volatility[iii] as Isabel Schnabel of the ECB has called it.

 

Building Robust Portfolios

A more volatile macro back drop supports the case for building a more robust portfolio with assets and strategies that can deliver returns in different environments. Maintaining a good balance between liquid and illiquid exposures may also be critical in managing capital and taking advantage of opportunities in a more volatile environment

The trend in recent years has been for private markets to be the first port of call when building alternatives allocations. Certainly, private equity, private credit, real estate, VC and infrastructure all have a place in a diversified portfolio.

However, when constructing portfolios it is important to look through to the underlying economic risks. A portfolio may look diversified with allocations to a range of different “buckets”, but economically it may be less diversified. Research from Bridgewater[iv] has shown that the typical institutional portfolio has a heavy bias to positive growth and low inflation.

Furthermore, as Sebastian Page highlights in “Beyond Diversification”[v] some seemingly diversifying assets and strategies may have a low correlation to equities in an equity bull market but become more positively correlated in times of stress when the economy turns down and liquidity dries up.

 

The Opportunity in Liquid Alternatives

The need to maintain liquidity while diversifying equity and duration risk point to liquid alternative investments as a particularly interesting option at the current juncture.

The range of liquid alternatives spans alternative assets such as gold and REITs to the range of trading and hedge fund strategies which are available with daily, weekly or monthly liquidity. Broadly speaking that includes much of the global macro trading universe, managed futures, market neutral strategies, volatility and tail risk strategies.

An important attraction of liquid alternatives is the potential to deliver returns in periods when traditional assets underperform such as in 2022.

Certain features of these strategies equip them to do that, specifically:

1. they are tactical (change positions in response to market and economic developments),
2. unbiased and opportunistic (can be long or short),
3. diversified (seek opportunities across many markets) and
4. trade liquid markets.

 

Diversifying Equity Risk

Within liquid alternatives it is important to evaluate strategies not only on their risk-adjusted returns but also in terms of their ability to deliver a convex return profile in times of equity drawdown.

Some hedge fund strategies may have attractive risk adjusted returns but a high correlation to equity, such as currency or credit strategies, and so are less diversifying to equities. Other strategies such as equity market neutral can be uncorrelated to equities but won’t necessarily deliver positive performance in times of stress.

Strategies like global macro and managed futures may have lower risk adjusted returns than other hedge funds but have historically delivered positive returns in major equity drawdowns which can justify a higher allocation from a portfolio perspective.

 

Performance of Various Hedge Fund Strategies in Major Equity Drawdowns, 2000-2022

Source HFRI/Archive Capital

That said, global macro and managed futures strategies are diversifiers rather than insurance strategies and investors need to be clear on whether absolute return, uncorrelated returns or tail risk protection is the objective for any allocation.

 

Inflation Protection

In the last two decades investors could rely on government bonds to generate returns in times of equity stress. However, in 2022 we saw how that relationship is contingent on inflation being well behaved. Although the consensus is that inflation has peaked for now, it is conceivable that we may see renewed inflationary upswings and diversifying inflation risk is likely to continue to be a consideration.

Over the long term equities and real assets should provide inflation protection but these assets can be marked down if interest rates rise in response to higher inflation. Again, some liquid alternatives can  serve as potential diversifiers for inflation risk. In a paper in 2021 researchers at Man AHL[vi] examined which assets and strategies performed best in inflationary periods. They found that within equities, Quality outperformed, and elsewhere gold, commodities and trend following strategies did well. The research proved timely because Commodity Trading Accounts, or CTA’s, performed strongly in 2022.

 

Summary

In sum, the changed macro environment suggests the era of beta investing of the 2010s may be over and the traditional negative correlation between bonds and equities may be less stable.

A more volatile macro backdrop argues in favour of building more robust, resilient portfolios with greater use of alternatives.

While private markets may offer interesting opportunities to enhance equity and growth risk in portfolios, adding liquid alternatives can add diversifying sources of return, particularly in a more volatile macroeconomic environment.

 

 

Alan Dunne is the Founder and CEO of Archive Capital. Prior to founding Archive Capital, he was Managing Director and a member of the investment committee at Abbey Capital. In total, he has worked in the financial markets for over 25 years at hedge funds and investment banks as a CIO, hedge fund allocator, macro strategist, and technical analyst.

About Archive Capital

Archive Capital is a boutique alternative investments and investment research firm focused on the use of alternative investments in asset allocation.  We work with investors looking to source, evaluate and allocate to liquid alternative diversifying strategies.

 

 

 

[i] Move Over, 60/40 Portfolio. You’re Out of Date Now, Lauren Foster, Barrons, May 2022

[ii] On the Cusp of a New Era, McKinsey Global Institute, October 2022

[iii] Monetary Policy and the Great Volatility, Isabel Schnabel, Speech at Jackson Hole, August 2022

[iv] Building A Beta Portfolio in an Environment That Looks Difficult for Assets, Gordon et al, Bridgewater Associates, May 2022

[v] Beyond Diversification: What Every Investor Needs To Know About Asset Allocation, Sebastian Page, 2020

[vi] The Best of Strategies for Inflationary Times, Neville et al, The Journal of Portfolio Management, August 2021

Author: Tim Sharp

Researcher: Jack Williams

Published: April 19, 2023

Gold, the precious metal often viewed as a hedge against uncertainty, war, and inflation, has been in the spotlight as it approaches its all-time highs once again. After hitting a peak of 2074.88 USD in August 2020 amidst the breakout of the Coronavirus pandemic, investors are now speculating whether there are further gains in store for gold or if the metal has reached its peak for now. In this week’s chart of the week, we will examine the historical trends and recent developments in gold’s performance, including its relationship with silver and the mining stocks for both metals and how they interact with each other.

Historically, gold has been considered a seriously defensive asset by investors, coining it’s ‘safe haven’ image amidst the inflation-wracked 1970s, where gold emerged as the best performing asset class, solidifying its reputation as a hedge against inflation. However, in recent years, gold’s defensive qualities have been called into question by the investor community as to whether gold still serves as an effective hedge, particularly considering its muted response to certain catalysts, such as the early days of the Russia/Ukraine invasion.

In recent months, gold has once again outperformed, fuelled by a confluence of factors such as the reopening of the Chinese economy, banking sector uncertainties, and investors seeking a hedge to equity markets as prices decline across sectors. These factors have contributed to the upward momentum in gold prices recently, especially since the turn of the year. Notably, while gold has historically outperformed silver in terms of raw price over the long term, there has been an interesting trend reversal when it comes to mining stocks for both metals.

While physical gold has outperformed physical silver, Gold miners have historically lagged behind silver miners in terms of equity prices, but in recent months, this trend has been shifting. The spread between gold and silver miners has been narrowing, with both gold and silver miners moving more in tandem with each other than they previously traded. This suggests a potential changing dynamic in the precious metals mining sector, which could warrant further analysis.

Year to date, gold has returned 9.79% to investors holding the commodity, while silver has returned 2.4% in the same comparable period. However, when it comes to mining stocks, gold miners, as tracked via the VanEck Junior Gold Miners ETF, have returned 6.07%, compared to the 8.28% return from silver miners. This indicates that silver miners have been outperforming gold miners in recent months, which is a noteworthy development to consider.

Considering these trends and recent developments, it is important to analyse the factors driving gold’s performance and its potential for further gains. While gold has historically been seen as a hedge against inflation, geopolitical tensions, and economic uncertainties, its effectiveness as a hedge may be influenced by various factors, including changes in market dynamics, investor sentiment, and global economic conditions.

One key factor that has influenced gold’s performance in recent months is the reopening of China’s economy. China, one of the world’s largest consumers of gold, has been experiencing a rebound in economic activity following the containment of the COVID-19 pandemic and the countries brutal Zero-covid policy, which has contributed to the upward momentum on Gold since the back end of 2022 and start of ‘23.

Another catalyst driving gold’s performance is the recent banking sector uncertainties following the downfall of Silicon Valley Bank and the merger between Credit Suisse and UBS. The banking sector has been facing challenges, including concerns about rising interest rates, potential inflationary pressures, and regulatory changes. These uncertainties have prompted investors to seek safe haven assets, including gold, as a hedge against potential risks in the banking sector.

Across the winder banking sector, opinions are divided as to how gold will perform for the remainder of the year, with some houses predicting a fall, some further rises to break above all time high and others expecting the metal to remain flat on the year. Listed below are some recent Gold forecasts issued by prominent banks.

Gold Price Forecasts Per Institution
Société Générale	$1550 Year End Target 2023
Fitch	$1600 Year End Target 2023
Reuters	$1750 Year End Target
Commerz Bank	$1950 Year End Target
J.P. Morgan	$1860 Year End Target
Wells Fargo	$1900-$2000 Year End Target

 

 

Sources:

https://www.jpmorgan.com/insights/research/market-outlook#:~:text=Commodity%20price%20forecasts%20for%202023,the%20fourth%20quarter%20of%202023.

https://www.ytdreturn.com/gold/

https://www.thenationalnews.com/business/money/2022/09/20/is-gold-losing-its-shine-as-a-safe-haven-asset/

https://markets.businessinsider.com/news/commodities/commerzbank-reaffirms-its-gold-forecast–looking-for-prices-to-end-2023-at-$1-950-an-ounce-12267260#:~:text=Commerzbank%20reaffirms%20its%20gold%20forecast,2023%20at%20%241%2C950%20an%20ounce&text=A%20magnifying%20glass.

https://www.hattongardenmetals.com/articles/aa2754/socit-gnrale-sees-gold-prices-falling-to–in–and-recovering-to–by.aspx

https://www.fxstreet.com/news/gold-price-forecast-xau-usd-target-range-for-2023-set-at-1-900-to-2-000-wells-fargo-202212291421

Charts: RefinitivData, Van Eck, GlobalX

 

Author: Tim Sharp

Researcher: Jack Williams

Published: April 12, 2023

 

Small Caps have pulled back recently, with many investors taking note of the correlation to credit conditions, which have tightened a fair amount in recent weeks following the fallout of Silicone Valley Bank and Credit Suisse a few weeks back now.

Events such as the SVB fallout can cause banks to become more hesitant of lending to both individuals and businesses. This makes accessing credit, and at a decent rate, that much harder.

Rate expectations in the US have fallen in recent months and despite stubborn inflation, interest rates are now seeing cuts being priced in for as early as Q2 23’ from some analysts. The question is, what are the fed to do? Risk growth deteriorating and causing a potential recession or, cut rates and unlock growth where inflation could then spiral.

As pictured on the left, rate expectations are coming down, with analysts predicting multiple cuts through to Q1 2024. The chart shows the current rate expectations in blue compared to its expectations a month ago in dotted line.

Strangely enough, consumers seem to be holding up. Amidst high inflation, rising costs of credit, an uptick in mortgage rates and cost of living pressures, consumers have weathered the current environment better than feared. Many investors had their hat hung on a recession due to a weak US consumer but have yet to see it fully materialise. While certain items have seen demand reduce, many companies are holding the line in terms of margins and being able to pass additional costs onto consumers.

Labour markets remain extremely tight, traditionally supportive of consumer behaviour, this data paints a differing picture than other economic indicators such as PMI’s which have been weak in recent reading and remain in contractionary territory.

 

 

 

 

 

 

Charts – Bloomberg / Barclays Research

https://www.forbes.com/uk/advisor/personal-finance/2023/03/23/inflation-rate-update/

https://live.barcap.com/PRC/servlets/dv.search?contentType=PDF&docviewID=6435d2cabba1a914d01ac9ab

https://live.barcap.com/PRC/publication/FC_TEJ-IH4gfiB-IH4g_6435d2cabba1a914d01ac9ab

https://www.ft.com/content/cb0f2aba-dee4-4ddb-b00a-61c5f6759092

https://www.bloomberg.com/news/articles/2023-04-09/end-may-be-in-sight-for-global-rate-hike-cycle-as-fed-nears-peak

Author: Tim Sharp

Researcher: Jack Williams

Published: March 22, 2023

 

Amidst the chaos in the banking sector this week, comes the destruction of Credit Suisse’s AT1 bonds, sending ripples through fixed income markets and causing hefty losses for bond giants such as Pimco who saw losses of $340 million on the banks AT1 product.

The deal between UBS and Credit Suisse leaves CoCo holders to bearing the losses while shareholders receive a small token with one share of UBS being exchanged for every 22.48 shares of Credit Suisse held.

Shown above is the WisdomTree AT1 CoCo bond UCITS ETF, which combines various AT1 products from across the banking universe to form a diversified ETF. Since the turn of the month, the funds value has fallen by nearly 12% and by more than 7.5% in the past 6 days alone showing the serious concerns of investors holding CoCo bonds, and investors uncertainty surrounding European banks in general. The fund now trades a mere 20 cents from the low it marked back in March 2020 when Coronavirus made its debut appearance.

AT1 bonds, otherwise known as CoCos (Contingent Convertible Bonds), have unique features dissimilar to other bonds investors may hold, they are issued by banks to raise capital. AT1 bonds are unique in the way they are designed to absorb losses in the event the issuing bank experiences financial distress. These bonds once again dissimilar to other bonds can be converted into equity or written off completely if certain conditions are met, such as falling CET1 ratios.

While CoCo’s tend to pay an exacerbated yields in comparison to other banking bonds, this is justified by being amongst the first few rungs of debt to be potentially restructured or written off when a bank comes into trouble such as we have seen with Credit Suisse in recent days.

While UBS has stepped in and made a deal for Credit Suisse, investors remain concerned about the wider banking market as seen by the huge declines in banking stocks across the EU, U.K and U.S. over the past week. Furthermore investors are now posing questions as to banks profitability after long swathes of time in low interest rate environments where deposits may have been hedged using fixed income securities now trading well below their waterline due to the rapid pace of interest rate increases employed by central banks around the world.

A mere month ago, financials was one of the most overcrowded, overweight sectors positioning wise. Now investors are reassessing the sector once again, having seen shares slide to the downside, this poses the question are the banks an opportunity at these levels, or something to avoid.

 

 

 

https://www.reuters.com/markets/rates-bonds/pimco-lost-340-mln-with-credit-suisse-at1-bonds-write-off-source-2023-03-21/

https://www.pimco.co.uk/en-gb/investments/gis/capital-securities-fund/inst-gbp-hedged-inc

https://www.theguardian.com/business/2023/mar/18/bank-runs-bailouts-rescues-are-the-ghosts-of-2008-rising-again

https://www.ft.com/content/fcfaea32-7288-49f8-acb0-84c846b157d9

https://www.theguardian.com/business/2023/mar/20/at1-bank-bonds-credit-suisse-bondholders-cocos

Charts:

1^st: Wisdomtree AT1 CoCo Bond Fund – LP68490358 1Yr Chart

2^nd : PIMCO GIS Capital Securities Inst GBP Hgd Inc – LP68227330

3^rd : Wisdomtree AT1 CoCo Bond Fund – LP68490358 3.5Yr Chart

Author: Tim Sharp

Researcher: Jack Williams

Published: March 12, 2023

Recent emergence of bearish data on the US economy, alongside the failing of two prominent financial institutions in the states such as Silicon Valley Bank, has prompted investors to reassess both the outlook for the US recession in the coming months, and the Fed’s ability to raise interest rates further.

Construction job openings in the US dropped heavily in January, plunging by more than 240,000, representing a near 50% fall from the prior month’s construction job postings figure.

Construction in the USA is a massive contributor to GDP and while it’s contribution as a percentage of GDP has been gradually falling in recent years, the sector still makes up around 3.90% of the overall GDP figure.

The near 50% fall witnessed in January was the largest ever monthly decline in construction job openings data history which has been running for nearly 20 years. On a wider lens, overall job openings dipped only slightly in January suggesting the wider economic picture is still at somewhat of a strength.

Figure 1 – US 2021 GDP By Sector

This matters as fed members in recent months have renewed their hawkishness and are looking to push ahead with further rate hikes, both of the recent banking collapses and the recent release of construction jobs data, which throws a spanner in the works, further complicating the issue.

Many investors believe the economic impact from the 4.5% worth of interest hikes the Fed has already delivered over the past 12 months have not been felt fully by investors. Economist Milton Friedman wrote in length regarding his view on the lag that monetary policy works with; Friedman claims it can take years for Fed interest rate changes to make their way through to the economy. Although useful to note, most of his monetary policy work was published in the late 60’s and the makeup of economies now are very different from what they were in the period his work was published, the interest rate was still relatively high around the time of his publications 4.6-5.7%.

This theory has already started being priced into markets with fed swaps pricing no additional rate hikes as the most likely scenario, and around an 80% probability being priced for no rate hike on the March 22^nd meeting. Vastly different from the probabilities the market was pricing even this time last week.

 

 

https://www.statista.com/statistics/248004/percentage-added-to-the-us-gdp-by-industry/

https://www.jstor.org/stable/1828534

https://live.barcap.com/PRC/publication/FC_TEJ-IH4gfiB-IH4g_640f47431055c101cec9f9ee

https://www.axios.com/2023/03/09/construction-softness-underscores-feds-tough-call

https://www.marketwatch.com/story/bank-debt-swoons-as-fed-moves-to-contain-fallout-from-sbv-signature-bank-collapses-9588e016

https://www.ft.com/content/7e7fdddb-724c-42fd-98ee-5d7248d53334

https://www.ft.com/content/b860ebb6-f202-4ec6-a80c-8b1527c949f4