Good days, bad days

Market volatility is a simple fact of life – it is always with us and as a consequence we just have to deal with it. Sell side financial institutions like it because higher volatility prompts corporate and retail investors to look for some form of asset protection, giving them the opportunity to write more tickets. They also like it because it is possible to make very decent returns if you time the entry and exit from your positions correctly. Conversely, retail investors hate it because their portfolio value can whip around without any obvious fundamental explanation.

How the professionals deal with volatility

Equity volatility is conventionally measured using the prices of index options with near-term expiration dates. The global benchmark is the VIX, which measures volatility for the S&P500. It is currently trading at 22, which is slightly above its long-term average of 19.5 based on data back to 1990 (chart above). This is not excessively concerning. Indeed, as I have noted on previous occasions (here, for example) markets have been far too complacent in recent years as central banks have anaesthetised them with their huge asset purchase programmes. Given the exceptional uncertainty surrounding the economic outlook in the Covid era, it is probably a good sign that volatility is perceived to be slightly above average.

Excessive volatility spikes are rare: We have experienced only a couple of major volatility surges in recent years – once in the wake of the Lehman’s episode in 2008 and another in 2020 as the Covid crisis began to unfold. Institutional investors can hedge some of the risk by investing in an Exchange Traded Fund (ETF) which moves inversely with the VIX. Such indices are only suitable for short-term hedging purposes – those who try a buy-and-hold strategy tend to get burned very quickly. This makes them unsuitable for retail investors who seek more durable protection.

Avoiding the downside yields bigger returns than chasing the upside

As it happens, one of the better protection methods is abstinence. To demonstrate the impact of volatility on investor positions I looked at daily equity market data going back to 1990. Starting with the S&P500 I calculated what would happen if investors missed out on the days with the biggest gains and losses and assumed that on those days the portfolio value reverted to the level prevailing in the previous period. Arbitrarily assuming that investors missed out on the 30 biggest single daily gains, a portfolio which tracked the S&P500 since 1990 would be almost 83% below one which included all trading days. By contrast, excluding the 30 biggest daily losses would have resulted in a seven-fold increase in portfolio value. Putting these two factors together by taking out both the top 30 increases and decreases, the index would have ended up almost 22% higher than one based on the S&P500 alone (chart below). The results are broadly similar for the FTSE100: excluding the largest 30 daily gains and losses resulted in a gain of almost 14% versus one based purely on the benchmark.

In theory we can extend our analysis for the S&P500 back to 1928 without materially changing the results although the volatility in the index during the 1930s means that more than half the biggest daily swings occur before 1940. Arguably the macro environment today is very different to that in the 1930s with economic policy much more sensitive to market volatility. Accordingly it seems reasonable to exclude the 1930s from the calculations. Running the calculations since 1940, and maintaining our exclusion threshold to encompass the top 30 gains would lead to an 85% loss but excluding the top 30 losses would increase the value of our portfolio ten-fold. Excluding both the highs and lows would increase our portfolio value by almost 60% compared to the benchmark over the last 81 years.

If you don’t have perfect foresight, hedge

This demonstrates two key takeaways: (i) big movements in indices have a disproportionately big impact on future gains, perhaps because they trigger sentiment shifts which generate a change in market direction and (ii) avoiding the worst excesses of decline have a bigger impact on portfolio returns than chasing the big gains. Obviously the foresight to know when we are about to experience a massive correction is not gifted to most of us, therefore the best we can do is to hold a balanced portfolio comprised of assets whose prices are either inversely correlated with equities or not correlated at all. As I noted last summer, the 60:40 portfolio strategy which comprises 60% equities and 40% bonds is as good a way as any to hedge risks.

The upshot of all this is that investors who pursue a minimax strategy (minimising maximum losses) are likely to outperform those who follow a maximax strategy (the aggressive maximisation of gains). Indeed the latter is viewed by many in the media as the way in which sell-side investment operates and some hedge funds still publicly hail such an approach as the ideal investment strategy. But a maximax strategy is like building a football team comprising only strikers. Whilst strikers score the goals and grab the glory, the team is unlikely to win anything unless the defence is strong enough to repel the opposition. In football terms a minimax strategy allows the team to build a stronger defence which will allow them to be more successful over the longer term. When it comes to portfolio investment we cannot eliminate our exposure to volatility but we can take steps to reduce our exposure to it. As in other areas of life, buying some protection can considerably reduce our long-term costs.

Left behind

Exactly eleven years ago, on 7 May 2010, we awoke to find that the Conservatives under David Cameron had emerged from the previous day’s general election with more seats than any other party. This proved to be sufficient for them to form a coalition government with the Liberal Democrats which lasted until 2015. The Tories have since won a further three elections under three different leaders and are unlikely to relinquish their grip on power any time soon. Although yesterday’s elections were less important than that of 2010, they were nonetheless an important litmus test of the state of domestic politics given that they represented the biggest plebiscite outside of a general election.

In England, 143 local councils (including London) were up for election; 129 members of the Scottish parliament were elected and 60 members were chosen for the Welsh Senedd. The full results are not yet in but the Conservatives have performed well in England and the SNP retains hopes of winning an outright majority in the Scottish parliament which will rekindle the issue of Scottish independence.

Labour’s decline and fall …

But the most significant result of the past 24 hours was the Conservatives’ victory at a by-election in the town of Hartlepool, called following the resignation of the sitting Labour MP.  This was a result of huge symbolism since Labour has held the seat since 1964 and indeed the Tories had previously only won the seat once since 1945. For those not familiar with the town, Hartlepool is traditionally one of the most solid Labour voting regions in the country, with roots in an industrial base extending back to Victorian times. Recent years have not been kind to Hartlepool as north east England’s industrial base has been steadily eroded (as a native of the region I have watched the steady process of deindustrialisation gather pace). As far back as 1971 the town recorded an unemployment rate of 12.3%, more than twice the national average, and in the early 1980s it was running at 33%. In 2016 the town voted 70-30 in favour of Brexit driven in part by the fact that successive governments had failed to deliver much prosperity to the area and its people were fed up. One can hardly blame them: In the words of Public Health England, “Hartlepool is one of the 20% most deprived districts/unitary authorities in England.”

We should be wary of reading too much into what most political commentators are calling a seismic shift in British politics and which the Labour Party itself described as a “shattering” blow. There have been numerous instances of by-election results over the years which have promised radical change only to find that business as usual was restored by the time of the next general election. But this time really does feel different.

One of the remarkable features of the 2019 election was the fact that huge numbers of voters in previously safe Labour seats voted Conservative (the so-called Red Wall effect). This was attributed to two factors in particular: (i) distrust of then-Labour leader Jeremy Corbyn and (ii) the promise by Boris Johnson to “get Brexit done.” In the subsequent 17 months Corbyn has vacated the leadership so in theory this should not have played a role (though there is a suspicion that he has poisoned the Labour brand). In addition, Johnson delivered Brexit and to the extent that a lot of Brexit Party votes in 2019 are likely to have transferred to the Tories in 2021, their Hartlepool triumph could be interpreted as a reward for getting Brexit done. There are also a number of other factors in play, notably the feelgood factor derived from the vaccine bounce and, perhaps more importantly, questions about what Labour stands for (see this article by political journalist Paul Waugh for more detail).

… despite the odds apparently being stacked against the Tories

What is even more striking is that the Tory win comes on the back of extensive media coverage of sleaze allegations against senior Conservative politicians. Former PM Cameron is alleged to have used his influence to secure aid for a company in which he had a significant financial stake. This was compounded by allegations that Johnson had improperly sourced funding to redecorate his flat in Downing Street; a spat with his former adviser Dominic Cummings on behind-the-scenes machinations in government and claims that Johnson was desperate to avoid a third lockdown at any cost (the “let the bodies pile high in their thousands” furore). In times past the torrent of bad news would have spelled doom for the Conservatives but it does not appear to have made a scrap of difference. In that sense there has been a seismic political shift.

What has changed? One possibility is simply that for all the frenzied speculation by journalists inside the Westminster bubble, the issue does not in any way impact on the lives of ordinary voters (there was no “cut through” to use the political jargon). After all, it seems that everybody accepts Johnson has a strained relationship with the truth and simply don’t care what he gets up to. Why should it matter to many voters that Johnson has engaged in “unethical, foolish, possibly illegal” actions if he has not personally inconvenienced them (not my view, by the way)?

A Europe-wide phenomenon

It is not only in the UK where the political centre-left has lost ground. The fortunes of the SPD in Germany have dwindled over the past decade to the point where the Greens are more likely than the SPD to form the next government if current polling results are repeated in the September election. Similar trends are evident across other European countries where centre-left parties have seen their vote shares collapse to varying degrees (chart below).

On the surface it would appear that there has been a reappraisal of the centre-left since the GFC (France being the partial exception where Francois Hollande won the presidency as recently as 2012). A one-size-fits-all explanation cannot be applied to all countries equally but there are some stylised facts which get us part of the way there. In many countries, what we once called traditional working class voters who worked in industry have become much more scarce and the retirees who once would have fitted that description are fewer in number. In addition to these demographic shifts, there is a sense that centre-left parties were left to carry the can for the fallout from the GFC. Many of them were in office in 2008-09 and chose to put in place austerity programmes which hurt their supporters the most, or they left power soon afterwards and were blamed for the austerity that followed. In reaction there was a surge in support across the continent for what could broadly be called right-wing (semi) nationalist parties as voters sought radical solutions to the economic woes that ensued. This was countered by a surge in radical left parties which overshadowed the more moderate centre-left.

Ironically, as Chris Giles pointed out in the FT last week, “the left is winning the economic battle of ideas.” As the pandemic has shown, government has a big role to play in stabilising the economy at a time of deficient private sector demand – a lesson which Keynes highlighted in the 1930s. As Giles put it, “the model of pre-coronavirus capitalism, with high levels of inequality, is losing popular support, suggesting the need for a post-Covid world with more support for the vulnerable and higher taxes, especially on extreme levels of income, wealth and profits.” If nothing else, this suggests that the policies of Joe Biden are in tune with a large part of his electorate.

Here in the UK, the Labour Party has tried to differentiate itself from its Conservative opponents in recent years by promising a bigger role for the state and increasing taxes on the more affluent. However, after having frightened voters by telling them that Labour planned to stymie efforts to reward enterprise, the Tories have since stolen many of their clothes by running huge budget deficits during the pandemic and committing to raise corporate taxes rather than lower them, as previously planned. Faced with this volte face, the centre-left are clearly going to have to find a different economic tune to play.

It is hard to know how to respond

For the British Labour Party, and indeed for their counterparts across Europe, it looks as though they will struggle to remain relevant unless there is a radical change of tack. Quite how that can be achieved right now is very difficult to imagine. They have nothing economically new to offer and in the UK there is no one who can compete with Johnson in the charisma stakes. Sometimes you just have to accept that it is not your day and the best you can do is hang in there and hope that the tide turns your way as the opposition makes mistakes. It is not a particularly palatable message for Labour leader Keir Starmer but it might be all he can do for now. If he cannot generate cut through sooner rather than later, the Labour Party’s spell on the sidelines looks set to continue for a long time yet.

Rethinking low interest rates

Over the years, prevailing economic orthodoxy has tended to follow fashions with policy makers pursuing a particular course of action only to subsequently switch tack and repudiate what has gone before. Very few people today believe that fixed exchange rates are a good idea (unless you happen to be in the euro zone where the rates of member countries have been fixed against each other for more than 20 years). Quaint ideas such as targeting money supply have also fallen from favour. Even the notion of using fiscal policy as a countercyclical tool, which was banished from the lexicon in the 1980s (apart from a brief reappraisal in 2008-09), is now part of the policy armoury. I thus wonder how long it will be before central bankers revisit the question of whether low interest rates do as much harm as good.

It has long been my view that central banks around the world made a policy error in not normalising monetary policy more swiftly in the wake of the 2008 crash. Although the contraction of global liquidity in the wake of the Lehman’s bankruptcy warranted a massive monetary response, there were few good reasons to justify why monetary conditions in 2012 were required to be quite as easy as those prevailing at a time of financial Armageddon. The Riksbank was one of the few brave enough to begin a tightening cycle in 2010 but the Swedish economy was caught in the backwash of euro zone turbulence and the central bank was forced to cut rates even below post-Lehman’s levels. I have often suspected that this policy about-turn deterred other central banks from making similar moves ahead of the Fed or ECB.

This is not to say that global interest rates needed to go back to pre-2008 levels. Factors such as demographics and the sharp slowdown in productivity growth justify a lower equilibrium real rate. However, one of the things economists warned about was that holding rates too low reduced the scope for conventional monetary easing in the event of an exogenous shock. That shock duly arrived in the form of the Covid pandemic and given the limited scope for rate cuts, central banks were forced to swell their balance sheets to unprecedented levels. This has opened up a whole can of worms. On the one hand it has sparked inflation fears whilst on the other it has led to significant market distortions, pushing up both bond and equity markets.

The inflation issue

Dealing first with inflation, this is a subject which has been at the top of the agenda throughout this year with the US 10-year yield hitting a 12-month high of 1.74% in March versus 0.91% at the end of 2020. At his annual shareholders meeting at the weekend, Warren Buffett warned that “we are seeing very substantial inflation.” Joe Biden’s huge US fiscal expansion plans have further raised concerns that the economy may overheat and Treasury Secretary Janet Yellen’s suggestion that “it may be interest rates will have to rise somewhat to make sure that our economy doesn’t overheat” sent ripples through equity markets which have been driven to record highs on the back of ultra-expansionary monetary policy.

However, we may be overestimating the link between monetary policy and inflation. The academic literature is unambiguous that there has been a change in the inflation process over the past 20 years. There is less agreement on whether that represents a weakening of the link between inflation and activity growth or whether the decline in inflation volatility is due a reduction in the volatility of economic shocks. In my view the former explanation counts for more in a world in which the rise of China as a major production centre has changed the dynamics of the global economy. That being the case, central bank actions in the industrialised world have played less of a role in driving down inflation than they like to believe. Accordingly, they may have less power to prevent any significant acceleration. Furthermore, if the link between inflation and the economy is less well defined than many suppose, it is harder to justify low interest rates on the basis of low inflation.

Are prolonged ultra-low rates even effective?

Whether inflation does or does not accelerate is not the focus of debate here. The bigger concern is that central banks appear fixated only on inflation as a measure of determining whether interest rates are at appropriate levels whilst ignoring a number of other factors. Indeed whilst central banks are right to take their inflation mandate seriously, there are a number of downsides associated with an ultra-easy monetary policy.

Starting with the bigger question, how sensitive are industrialised economies to interest rates anyway? My own modelling work always came to the conclusion that the UK was never particularly sensitive to interest rate moves. More detailed academic work by Claudio Borio and Boris Hofmann at the BIS suggested that monetary policy tends to be less effective in periods of ultra-low interest rates. They noted further that “there is also evidence that lower rates have a diminishing impact on consumption and the supply of credit.” Two reasons were given for this: (i) the conditions which prompted a cut in rates to the lower bound in the first place (a balance sheet recession) generate economic headwinds which make recovery more difficult and (ii) the impact of low rates on banks’ profits and credit supply generate feedback effects which impede recovery. We only need ponder the Japanese experience of the past 20 years to realise there may be something in this.

The market impact

Although the economy in the industrialised world has not boomed in the last decade, equity markets clearly have with the Shiller 10-year trailing P/E measure on the S&P500 last month trading at a 20-year high of 36.6x. Prior to the March 2020 collapse I did note that the prevailing level of 31x pointed to a market that was too expensive but we are now at the second highest levels in history (chart below) – lower than in 1998-2001 but above 1929 levels.

This in turn raises a question whether central banks have a duty to take account of financial asset prices in their monetary policy deliberations. Former Fed Chairman Greenspan used to take the view that we could not spot a market bubble until it had burst and that the role of monetary policy was to mop up after the fact. That view no longer holds since we can clearly identify that US markets are in bubble territory. To the extent that central banks are increasingly responsible for financial stability it is incumbent upon them to ensure that the banks which they monitor will not be adversely impacted by a market correction. In fairness, banks are subject to regular and rigorous stress tests and central banks are confident that capital buffers are sufficiently large to withstand a major market shock.

However, the gains from high asset valuations generally accrue to high income households which has distributional consequences for the economy. Central banks can rightly argue that this is not part of their mandate and is therefore not something they have to worry about. But to the extent that governments, which set the mandate, do care about distribution there is a case for central banks to at least think about this problem before it is forced upon them. Then of course there is the ongoing problem of what low interest rates do to savers, particularly those with an eye on retirement – a problem I have highlighted on numerous occasions. Most people do the bulk of their retirement saving in the last ten years before they leave the workplace – precisely the time when they are advised to reduce equity holdings and overweight their pension portfolio towards fixed income. Pension annuity rates remain nailed to the floor in this low interest rate environment (chart below) which means that retirees get a much smaller payout for any given pension pot than they did in the past. Low rates clearly have generational consequences.

Last word

I am not advocating that central banks should imminently raise interest rates. Indeed any such move is only likely to occur well into the future. But in a post-Covid environment where fiscal policy is likely to be much looser than in the wake of the GFC, there will be less need for monetary policy to do most of the heavy lifting. This should at least stimulate a proper debate about the pros and cons of ultra-low (and in some cases negative) interest rates which has been lacking over the past decade.

Is anybody happy?

My original intention in writing this post was to look at the trials and tribulations in British politics as allegations of financial impropriety raise major question marks against the conduct of senior politicians which in turn has stirred a major debate about standards in public life. This is a theme to which I may yet return but I realised that this political split reflects a much deeper social schism and one which is not merely confined to the UK. Ultimately the issue is whether the economic system is working for the majority of voters or is it a system which is rigged in favour of political insiders. Simply put: Are electorates happy, and if not why not?

Measuring the mood

It is very difficult to put one’s finger on the national mood and measure the extent to which society is at peace with itself. Indicators such as consumer sentiment do not really do the trick for although they capture economic well-being, society can still be restive even when the economic indicators appear strong (and vice versa). In the 1970s and 1980s economists popularised the misery index (the sum of the inflation and unemployment rate) to try and provide a link between economic and social well-being but this has fallen out of favour in recent years as both inflation and unemployment have fallen. Ironically the US misery index during Donald Trump’s term of office posted the lowest average of any president in the post-1945 era. But as the Capitol demonstrations indicated in January, US society is far from being at ease with itself.

In recent years, economists and statisticians have attempted to broaden their measurement of well-being beyond looking at GDP growth, unemployment or inflation. One of the limitations of these standard measures is that they take no account of distributive aspects which have become an important agenda item since the GFC of 2008-09 and which were given additional prominence by the work of Thomas Piketty. Indeed, the perception that the benefits of economic recovery over the past decade have accrued to an economic elite (the haves) at the expense of the rest (the have-nots) was one of the driving forces behind the election of populists such as Trump and Bolsonaro, and was very much at play during the Brexit referendum in 2016.

An alternative to using GDP which has become popular in the academic literature is the Genuine Progress Indicator (GPI). This attempts to measure economic welfare and differs from GDP in as much as GPI attempts to distinguish between welfare enhancing and welfare-reducing activities whereas GDP simply assigns a positive monetary value to all activity irrespective of its social welfare impact. GPI starts with the national accounts measure of consumer spending and adjusts for a range of 24 factors including income distribution and environmental costs, and also accounts for negative activities like crime and pollution.

It is far from perfect; for example, it is not a measure of sustainability, therefore activity which adds to social welfare today but which subtracts from it in future is still classified as a positive addition to GPI. Nor does it capture all types of social benefit; for example, it omits factors such as political freedom which can substantially add to social welfare. Nonetheless, it is a useful first attempt to account for welfare issues and is vastly superior in this regard to GDP. One of the great ironies is that a study conducted almost a decade ago[1] concluded that the quality of life in Britain based on the GPI reached a peak in the 1970s – a period which politicians have told generations of voters was actually one of great economic hardship.

Another problem with what we might call indicators of material well-being is that they are not necessarily correlated with quality of life indicators. Precisely because quality of life measures are highly subjective, with different people assigning different weights to the same factor, it is not easy to devise an aggregate measure of well-being. However, the OECD has created a website which allows users to create their own index based on three indicators of material prosperity and eight quality of life measures. The results can be broken down into detailed geographical regions and those based on participants in three global cities are shown in the chart above. It is interesting that the most important factors for Berlin and London are broadly similar, with safety a top priority in both cases but across the Atlantic in Washington DC, survey respondents prioritised income.

Whilst the idea of creating an index on a snazzy, easy to use website may look like a fluffy exercise in optics, the results are far from trivial. If society is to repair some of the divisions which have been allowed to fester over recent years it is important to understand what factors are important to people and how well their objectives are being met. The results of the OECD analysis suggest that a government which places its focus in improving the quality of health outcomes or social safety will do well in Europe but US governments have to prioritise policies which deliver strong incomes.

Energising younger voters will be crucial

All this was brought into focus by an article in the FT by the always excellent Sarah O’Connor who looked at the challenges facing younger people in the wake of the pandemic. The article references a global survey which the FT conducted of those aged under 35 which canvassed the opinions of 1700 people (the results are summarised in the chart below). Two issues particularly stood out from the reader comments: the cost of housing and the burden posed by student debt (a topic I looked at here). One survey respondent noted that “most people my age are paddling so hard just to stay still … and many are losing faith in the system.” Another commented “it feels as if “we are drowning in insecurity with no help in sight.”

The political angle to all this is that western governments have for many years prioritised average income, as represented by GDP, at the expense of distributional issues. In the Anglo Saxon world, governments have slashed taxes for the wealthy over the past four decades, which has allowed the rich to become richer whilst the middle earners have been squeezed and those at the bottom have done extremely badly as the welfare safety net is eroded. The perception of extremely wealthy capitalists rubbing shoulders with politicians at venues like Davos has contributed to the sense – real or imagined – that public service is increasingly a licence to make money. The likes of Tony Blair and Gerhard Schröder, for example, became very wealthy after they left office by taking on a variety of different jobs.

Moreover, it is a well-worn political “fact” that older voters are more likely to head to the polling booths than younger ones. Accordingly the economic and political system is biased towards older voters for it is their votes that keep politicians in office. However today’s younger generation will be tomorrow’s mature voters but it appears they have little incentive to engage with the system as it stands today. Stories of rows amongst government ministers and the chummy relationships between senior politicians and private sector companies do nothing to persuade young voters in particular that the system has anything to offer them. The post-Covid response will demand politicians engage with the electorate in a different way to that of recent decades in order to tackle issues of importance to a new generation of voters, such as climate change and securing long-term prosperity. On the basis of recent events in the UK, politicians seem to be making little headway on this front.

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[1] Kubiszewski, I., R. Costanza, C. Franco, R. Lawn, J. Talberth, T. Jackson, and C. Aylmer (2013) ‘Beyond GDP: Measuring and achieving global genuine progress,’ Ecological Economics, 93, 57-68