Clearly, it’s not going to be possible to get through a single trading day without a new notable note (and no, there are no typos in there) on the low vol. regime.
Just yesterday, we penned our latest take on this du-jour-est of topics du jour, in which we highlighted a Wall Street Journal article that essentially suggests homegamers-turned-vol-sellers are likely to get run over at some point in the not-too-distant future.
Fast forward 12 hours (give or take) and Goldman has something new in which the bank asks what you should own if, as they expect, the low vol. regime persists.
At this point it isn’t entirely clear whether people are writing this stuff to actually enlighten investors or whether this has simply devolved into a game of one-upmanship with everyone scrambling to see who can pen the best low vol. missive or, perhaps more accurately, the most low vol. missives in the shortest period of time, but whatever the case, I suppose Goldman’s latest is worth excerpting.
Or maybe it’s not, because basically they are telling you that the best performing assets in low vol. regimes are risk assets – which isn’t exactly surprising.
Anyway, go buy yourself some goddamn stocks and junk bonds…
In low vol periods what assets have the best risk-adjusted performance?
As we [have] shown, credit and equity tend to have the best cross-asset performance during low vol periods, while bonds and commodities underperform. Exhibit 1 shows that this has also been true of risk-adjusted returns: the S&P 500 and US HY credit have had roughly 9 and 19 times the risk-adjusted returns of US 10-yearTreasuries, respectively, during these periods, while commodities have lagged materially. Prior to 1990 non-US bonds did quite well, but this is likely because global markets were less connected than today and that we use the S&P 500 to determine our volatility periods. Since 1990, bonds have done poorer relative to other asset classes, especially this time.
Improvements in risk-adjusted performance matter as well, not just the level. Assets with the greatest (least) improvements in risk-adjusted performance relative to their history would suggest overweights (underweights) relative to the benchmark, while in line performance suggests no deviation. Equities have the most dramatic improvement in risk-adjusted returns during low vol periods, particularly non-US equities, as return-to-vol ratios have been c.5 times higher relative to their historical average. The improvement in US HY has also been materially positive (3.1 compared with 1.4), while for US 10-year bonds the shift has actually been towards worse risk-adjusted returns compared with history.
The outperformance of US HY credit compared with other asset classes is not unique to low vol periods. As Exhibit 2 shows, c.80% of the time US HY credit has better risk-adjusted returns than the S&P 500, and they are 4 times as large on average. As returns have been largely in line between US HY and the S&P 500, the difference in risk-adjusted returns is primarily due to the materially lower volatility of US HY – it generally has vol significantly lower than even US Treasuries (Exhibit 3). This tends to be driven by the negative correlation between credit spreads and risk-free rates as we are considering total returns. Negative risky/risk-free asset correlations have boosted hybrid assets and portfolios in particular since 2000.
How have these assets performed this time?
Risky assets are materially outperforming their historical risk-adjusted performance in other low vol periods, as Exhibit 1 shows. But for some assets the level of performance, while strong, has not been materially different from what we should expect given history. Exhibits 4 and 5 show performance for the S&P 500 and US High Yield credit since the start of this low volatility period, compared with their average returns from the start of 14 other low volatility periods. Although this time US equities have outpaced their historical averages during such periods, this outperformance has actually not been that material (+5%), and the trend would suggest this level would be reached in about 2 months anyway. Similarly, US HY credit returns have performed in line with the previous low vol periods.
However, these assets’ valuation behavior has diverged. Exhibit 6 shows the cumulative change in the S&P 500 P/E from the start of low volatility periods, showing this time it has been in line with increases in equity valuations we have seen in similar periods. Obviously the level of equity valuation is higher, but that was true before entering the low vol period. The change in credit’s valuation has been far more material (Exhibit 7). And it is not just that credit spreads have compressed more than in other periods, as they were wider at the start of this low vol period than previous ones historically, presumably creating more scope for compression. But spreads have also compressed to a level that is c.100bps tighter than they have been at the same point in similar periods, on average.