The current prevailing bias is pretty bullish on risk assets. While we don’t have a quarrel with the way price has responded to news, it is still a valid exercise to think about ways to manage downside risk or hedge portfolios if there was a correction in risk assets. A simple way to do this is to manage how much equity exposure (or equity beta) one has in their portfolio. That would include assets like credit and high yield currencies that are correlated to equity. As equities rally it might be appropriate to reduce aggregate equity exposure or portfolio beta to equity.
Alternatively, it is useful to think about “diversifiers” to equity. In recessions, sovereign fixed income has been a diversifier or hedge for equity. However, in periods of high inflation, commodities have been a more effective hedge. Put another way, the regime matters. A third alternative is to buy protection (a put option) or long volatility. Of course, long option positions cost money and are usually too expensive to hold on a sustained or systematic basis. Nevertheless, if the cost of protection is cheap, it might be attractive to accumulate some protection and therefore allow the investor to maintain long exposure to equity (or equity beta). Often volatility or the cost of protection can be cheaper in markets other than US equities although liquidity is also an important consideration.
Super-abundant excess liquidity and the strong macro news flow as the economy re-opens has clearly supported equity prices and risk assets more broadly. Curiously, while most risk assets have benefited, volatility has compressed in some assets more than others. As a result, the cost of protection is more attractive in some markets relative to others. While US equities have led cross asset returns, the high yield credit spread in the United States has compressed into 278 basis points which is below pre-COVID levels and only modestly above the record trough prior to the 2008 episode.
In contrast, although US equity volatility (as measured by the spot VIX) has also compressed, it still remains wider than pre-crisis levels and only modestly below the average since 2005 (chart 1). However, our sense given the constructive fundamental outlook is that convergence is more likely to occur through US equity volatility compressing toward high yield credit spreads (risk premia) rather than the other way around. Stated differently, it is the high yield market that current has insufficient compensation for risk.
Equity volatility is also more compressed in some regional markets relative to the United States. In particular, the Australian Stock Exchange Volatility spot index is currently at 11 compared to 16.6 for the US VIX Index. KOSPI and HSI volatility are at comparable levels to the United States, but are lower relative to their own history. The ASX stands out in terms of providing inexpensive cost of protection in both outright terms and relative to history (chart 2). The ASX VIX is almost 1 standard deviation below average over the past decade. To be fair, US, KOSPI and HSI index volatility increased by considerably more during the recent episode and in the 2008 crisis.
On a cross asset basis, the absolute level of fixed income volatility either in the US market or EM is lower than equity volatility, but EM debt volatility is comparable in standard deviation terms. Similarly, Yen-cross rate volatility is also lower than equity volatility in absolute terms and relative to history. AUD/JPY or US fixed income volatility are both less expensive, but have been less effective since 2008. That might be a function of greater policy interference (and reduced interest rate carry) in the fixed income and currency markets over the past decade. Nevertheless, in a “proper” episode, Japanese institutions tend to repatriate large foreign assets and drive up the value of the yen. The table below shows a range of cross asset volatility shown in z-score or standard deviation terms (chart 3).
In conclusion, we remain net long and constructive on equities given super-abundant liquidity and improving macro conditions. However, those conditions are a reflection of the prevailing bias and risk premia has become quite compressed in a range of assets, most notably high yield credit. In that context, the cost of protection appears inexpensive in Australian equities, US fixed income and yen cross rates on carry/growth currencies.
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.