Since the GFC, macroeconomic events have become strong drivers of asset returns. Loomis Sayles has now developed a crisis sensitivity ratio model to better understand how these events impact markets.
‘This Time is Different’ are the four most expensive words in the world, Sir John Templeton once famously said.
Yet, the investment environment since the global financial crisis certainly has a set of unique characteristics to it.
One of those characteristics is that macro-economic events have had far-reaching consequences for assets in almost any market, as central banks flooded the markets with cheap money and a pandemic has put pressure on global economies.
It has, therefore, never been more important to incorporate a top down approach as part of the investment process, Andrea DiCenso, Portfolio Manager and Senior Strategist at Loomis Sayles, says.
“Most deep value investors built their portfolios from the bottom up and however their regional exposures turned out to be, that’s what it was,” she says in an interview with [i3] Insights.
“But when you think about the shift in macro-economic policy since the global financial crisis, it really has been the last 10 – 11 years, where investors no longer had to be just focused on the sector or the asset class they traded.
“Equity investors also had to care where global rates were and what central banks were doing, because that ebbing and flowing of liquidity in and out of markets was having a direct impact on their holdings.
When you think about the shift in macro-economic policy since the global financial crisis, it really has been the last 10 - 11 years, where investors no longer had to be just focused on the sector or the asset class they traded. ... investors also had to care where global rates were and what central banks were doing, because that ebbing and flowing of liquidity in and out of markets was having a direct impact on their holdings
“It was the same for fixed income investors. We’ve had to say: ‘Okay, it is not all just about the bottom-up fundamental analysis’.
“We needed to be part-time economists and factor in what central bank action was coming down the pipeline and how that impacted the shape of the yield curve or even just the future growth and spending of a government. And what did that mean for the corporates operating in that sovereign nation?
“Especially in a post-global financial crisis world, getting those macro calls right, understanding where to take risk and having a regional perspective was probably one of the most important starting places for investing,” she says.
DiCenso looks at individual markets and identifies which part of the credit cycle they are in. She splits the global credit cycle in four stages: downturn, credit repair, recovery and expansion, and late-cycle.
“The crux of understanding is where every country is trading within the global credit cycle,” she says.
“Unfortunately, we are experiencing the coronavirus now which could be the culprit here, but traditionally we were looking into the areas of the real economy – the banking sector, the corporate sector and the household sector – and really drill into all the key inputs into a growth engine of an economy and to understand is leverage building or falling?”
Most top down processes rely on a set of leading indicators, providing information about variables, including GDP growth, unemployment rates and productivity. But the problem with these indicators is not only do they present lagged data, but they are also essentially backward looking measures, giving little information on what may lie ahead.
Therefore, Loomis Sayles has been working on a model that looks ahead, relying on a risk premia engine that assesses relative value across markets.
“If we would just sit around and wait for these indicators to tell us that a country is tipping into a downturn, then we could be anywhere from one to six months late to the party,” DiCenso says. “Markets would already have repriced by then.
“So the second ingredient in our process of getting the top down correct is measuring market fragility,” she says.
Apart from her role as portfolio manager, DiCenso is a senior strategist in Loomis Sayles’ Alpha Strategies team. This team has developed a number of quantitative tools to help them assess markets.
More recently, they have applied these tools to assess relative value between the various credit markets and this model gives them a sense of any stress building up in the financial system.
“What we are looking at is how the co-movements of each of the underlying constituents of the indices are moving,” she says.
“I don’t want to simply call it correlation, because it is not as simple as that, but it is along that line of understanding. Are those constituents rising together or falling together or just acting as it normally would?”
If we would just sit around and wait for these indicators to tell us that a country is tipping into a downturn, then we could be anywhere from one to six months late to the party
DiCenso gives an example where she compares the factors driving returns of an energy stock to that of a technology stock. Given that they are stocks from different sectors with very different profiles, the movement of these stocks should not show many similarities in a normal market environment.
But there are times when they do and often it is a sign of stress building up in the market.
“One could ask: ‘Is there a reason for these two not to be trading at their fundamentals anymore and purely off market momentum?’,” she says.
The team has developed a measure of market fragility that has three levels: low, medium and high. They call this the ‘crisis sensitivity ratio’.
“We are trying to classify all of these markets into these three states. If it is a healthy market, then that would be a low crisis sensitivity ratio. Are we starting to see interconnectivity building across the constituents within an asset class? That would be a medium crisis sensitivity ratio. And then flashing red is when you no longer are getting that diversification benefit,” she says.
“Incorporating these market-based measures into our approach, we found that we were able to start adjusting the portfolio exposures before you start to see large repricing in the market itself. It is much faster than relying on macro-economic data,” she says.
Applying the Model
Applying the model to markets saw Loomis Sayles shift its portfolios away from emerging market (EM) debt and the lower quality end of high yield bonds, back to high quality assets, when heading into 2020.
It was a timely decision as only a few months later markets started to plummet as the coronavirus pandemic swept the world.
“What we are trying to achieve with the model is that we are looking at the constituents of many global indices to understand the factors that are driving returns. In a typical healthy market, there are many factors that you can isolate to help explain returns, but in a very fragile market, which we saw play out from the middle of March throughout April, you end up with very few factors explaining returns,” DiCenso says.
“We saw the crisis sensitivity model begin to flash red and the first warning sign that we got was from the Chinese equity market. That was in February and it makes sense: most of China was in lockdown by then and it was unknown how long they would be there.
“But really you didn’t see that contagion spread to other markets at that point. You really still saw other markets still operating with pretty healthy market indicators,” she says.
The second warning came from European bank equities towards the end of February as parts of Italy and Spain went into lockdown, DiCenso says.
“If you think about what drives global GDP, then it is Europe, the US and China. They represent over 50 per cent of global GDP. So now we are beginning to have the main drivers of global GDP entering lockdown and large parts of their equity markets starting to flash warning lights at us.
“But it wasn’t until the beginning of March until we saw the crisis sensitivity begin to flash a warning sign for US equity markets. And really by the beginning of March, if we had waited to position our portfolio up in quality at that time, it would have been nearly impossible to truncate our drawdowns at that point because you almost could not transact, even in the most liquid markets: the US Treasury market, the foreign exchange markets globally.”
But the Loomis Sayles credit team had already started moving out of single B, emerging market credit at the start of the year and now it decided to put hedges in place to manage the overall risk in the portfolio.
“Using that crisis sensitivity ratio in conjunction with our risk management measures – so utilising high yield credit default swap indices, EM credit default swap indices and extending the duration of our portfolio – really allowed us to be in a better position in March, when you saw the Federal Reserve being the first to step back in and support global liquidity,” she says.
Governments and central banks around the world reacted swiftly and in an unprecedented way to the onset of the corona crisis. For the first time in history there was a truly coordinated global response, where you had both central bank liquidity provision and government fiscal spending both firing at full force.
This meant it was time to add some risk back into the portfolio.
You don’t want to be fighting central banks when they are pushing liquidity into the markets. That is a losing trade. So as long as global central banks are providing that backstop, you have to be aware of it and you have to adjust
“You don’t want to be fighting central banks when they are pushing liquidity into the markets. That is a losing trade. So as long as global central banks are providing that backstop, you have to be aware of it and you have to adjust.
“You have to adjust in the way you value assets, because it is not purely based on valuation. Valuation alone is not a good timing tool; you probably need a momentum indicator on there too. And that is really what this crisis sensitivity ratio is meant to capture,” she says.
“So heading into Q2, we migrated our investment grade exposure down in quality, so we were taking away from that AA and A, exposure and moving it down towards BBB,” DiCenso says. “At the end of March, we were running more or less a BBB portfolio.”
“But we also found a tremendous amount of opportunities within emerging markets and within developed markets in that single B area. When you are in a risk-on environment, then two thirds of your returns are going to come from single B’s. So getting that single B call correct can make or break a year for you.”
“We were able to find a lot of opportunities in the single B and BB space. Right now, as it stands our portfolio is a high BB portfolio.”
The Loomis Sayles credit team also shifted its regional exposure as the pandemic developed, taking more exposure levered to growth within Asia and Europe.
“With China and Europe coming out of lockdown faster than the US, we wanted to make sure that we were taking advantage of the growth optimism in those regions and the assets that were best set up to take advantage of that,” DiCenso says.
“So we had a shift away from European assets in the beginning of 2019, because we thought the US was really one of the main growth engines into 2020, but as soon as we saw the US response with lockdowns lagging behind all other countries in Q1, we had shifted our exposure back to Europe.
“In April, we also shifted our exposure to African countries and the Middle East, areas in the world that are heavily leveraged to Asia and the manufacturing cycle within Europe,” she says.
This article is paid for by Loomis Sayles. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.