Management without boldness does not perform, while management without discipline is reckless
Investors are notoriously uneasy when it comes to managing the risk that an impending political event presents to their savings. The recent market correction following the Brexit referendum offers a striking illustration of the danger in binary wagers, especially when no value is added. With the risk of Brexit all but ruled out in the last opinion polls to be published, many investors gorged themselves on an apparently safe bet. In doing so, they broke two basic rules of risk management in one fell swoop: 1) always keep a free mind and have the courage to go against the flow, especially when it is one-way; 2) keep from highly asymmetric risks. The referendum risk was just that: a Remain vote was virtually a non-event, whereas a surprise majority in favour of Leave would inevitably have a seriously negative impact on the markets, which is what happened.
This also reminds us that risk management does not stop there. The markets' brief speculative exuberance now over, the task will be to factor this new event into an objective risk analysis and decide, whether or not, the markets might be blinded by fear. Risk management also involves risk taking. This often means being too early, or making mistakes sometimes. More than a question of technical expertise, risk management is a matter of judgment and character. To put it bluntly, expertise is knowing that the tomato is a fruit from the nightshade family; wisdom is not putting it in a fruit salad.
Weaker global growth was already the main risk to the markets, Brexit confirmed this
The UK vote would not have been such a big deal if the global economy wasn't so fragile. One has to bear in mind the markets' regime change, which we highlighted in our newsletters for July 2015 ("The Great Transition Has Started"), March 2016 ("Sleepwalkers") and April 2016 “Dancing on a Volcano”). Global equity markets' 70% rise from 2011 to 2015, when corporate earnings were unchanged, was largely an act of faith, assuming that it was only a matter of time before profits climbed on the back of more sustained global growth resulting from central banks' persistent intervention. However, this confidence started to wane in 2015. Just as the Federal Reserve was bringing its third round of quantitative easing to an end, corporate earnings went into decline around the world.
Equity markets started to relinquish their past gains, and long-term yields dropped even more steeply. The credibility of the Bank of Japan and European Central Bank began to fade, making the poor level of growth actually achieved (nearly eight years after the collapse of Lehman Brothers, there are still 4.5 million more unemployed people in the Eurozone than there were in 2007) even more vulnerable to any external shock. Three "shocks" have occurred since then: the renminbi's devaluation in August 2015, the oil price slump in January 2016, and now the Brexit vote, each one posing a new threat to global growth and fuelling market instability.
Overlapping economic and political risks
The lack of economic growth is starting to have visible political effects. In the United States, stagnation of the median real wage since 2000, during which time quantitative easing has made the wealthiest households even richer, enhances the popularity of Donald Trump's populist, protectionist posturing. A gloomy economic outlook in the European Union was a major factor in David Cameron's inability to convince a majority of UK voters to put their fate in EU hands. Similar causes having similar effects, the lack of economic success in Europe could lead to further discontent (in June and December 2014, we had already entitled our newsletters "Unhappy Europe" and "Lost in Stagnation"). Protest votes will become more commonplace at forthcoming elections if Europe cannot rediscover the path to growth, and will summon the spirit of disintegration. If it wants to avoid the dangers of increasing reflexivity between political tension and slower growth, Europe - Germany in particular - will have to get to grips with the risks inherent in maintaining the economic orthodoxy.
Paradoxically, could the Brexit shock provide a welcome, if not life-saving, jolt?
It is now plausible that the markets might start preparing for the next stage, which would involve recognising the economic ineffectiveness of quantitative easing, while expecting fiscpolicies – hitherto considered "impossible" given the state of public finances – to start taking over. Politically, will the “traditional” political class be capable of an unexpected awakening after sensing the wind of change? Moderate voters tempted by breakaway rhetoric could see the political and even economic crisis unfolding in the UK as a clearer sign of the dangers of playing with fire.
Boris Johnson's desertion a few days after the Leave campaign's "victory" could also foster a more critical view of blatantly populist arguments. From this perspective, the poorer-than-expected results of the Unidos Podemos movement in Spain's recent general election, which immediately followed the Brexit vote, are encouraging. In the meantime, at the very least, it is likely that central bankers will confirm or even step up their short-term support. The Bank of England has already said as much, and the Federal Reserve will probably be even more reluctant to tighten financial conditions.
Priority given to balancing portfolios
Heightened risks of a global economic slowdown are encouraging us to leave the general composition of our portfolios unchanged. Their regional diversification and balance between high visibility stocks, European bank bonds, gold stocks, safe haven currencies and US Treasuries, which fully served their purpose when the markets slumped on 24 June, are likely be broadly maintained. As we expected, market instability - now confirmed three times - supports our decision to manage exposure levels very actively to take full advantage of transitional movements.
Against a backdrop of low or even negative interest rates, claiming to generate long-term performance without taking risks would be a greater fallacy than ever before. The evidence suggests that the quest for performance starts by being daring, and endeavouring to be right more often than wrong. Though it may seem obvious, this long-term objective is by no means trivial: independent analyses show that the best long-term fund managers make the right decisions around 60% of the time. But not all errors are created equal; for example, the five worst months for the S&P 500 index in the last 20 years wiped out 50% of its performance (which drops from +560% to +236%).
Management without boldness does not perform, while management without discipline is reckless.
Risk management means paying careful attention to asymmetric risks and being constantly aware of one's responsibility to justify clients' trust. Freedom of thought makes this possible.
The UK vote to leave the European Union sent shockwaves through the markets. As we expected, the most abrupt adjustments were to exchange rates with the pound falling steeply and the yen rising just as sharply, providing its usual safe haven.
While the euro slipped against the dollar following the UK referendum, it was relatively stable over the month as a whole. In this context, our balanced but active currency strategy, with long positions on the yen and hedging of sterling, is helping our risk management as we make it through this volatile period.
Safe haven securities such as US, German and Japanese government bonds fully served their purpose following the Brexit vote, with yields falling by between 10 and 30 basis points. Yet other sovereign bond markets came under no serious pressure. Peripheral European bonds saw their yields remain well below their early year levels. Better still, sovereign bonds of such emerging countries as Mexico and Brazil saw their yields drop further.
Along with central banks' renewed indications that they are ready to soften any blow, the fears that Brexit aroused about growth prospects have created excellent conditions for bonds in general. As a result, we kept our modified duration at a reasonable level with positioning diversified among peripheral government bonds, corporate bonds and emerging market sovereign debt.
After wrongly predicting a Remain vote in the UK referendum, equity markets underwent a sharp correction before picking up in the last few days of the month. The net performance that resulted from this instability was especially bad for Eurozone markets, as well as the Japanese market, which ultimately lost more than 7.5%. Conversely, benefiting from the safety valve of a cheaper pound, the UK market was one of the most robust with a gain of 5% over the period.
These developments closely reflect the importance of a balanced portfolio, and of taking exchange rates into account in risk management. Our positioning in non-cyclical stocks including healthcare companies (the ageing population theme being the heaviest weighting for our global strategy), and the addition of positions to manage the overall level of risk to portfolios (such as gold mining companies, which gained more than 15% over the month), meant that our asset-based approach served its purpose in this turbulent period.
Carmignac Portfolio Commodities posted a stable performance over June. In line with our global risk management, we increased our exposure to gold miners at the beginning of the month by adding Royal Gold to the portfolio.
We also opened a position in oil company ENI before taking advantage of the markets' volatility to raise the Fund's total exposure cheaply at the end of the month.
Funds of funds
Our funds of funds turned in a stable performance over June. Our balanced positioning was the cornerstone of our risk management, allowing the various profiles to absorb the markets' volatility.