Now cash is king

-The markets opened up on a positive note in October with a broad-based rally in risk assets, led by equities. Despite the dire performance of the global equity index MSCI All Country World Index (ACWI) in September which plummeted by 9.3%, October started on a rather positive note with a 5.9% rally in the index on its first two trading days.

–There were two main reasons driving the markets. First, the dip into an oversold territory meant that there were fewer or no market players who could add to their short positions. Hence this was a reaction to the sharp decline in prices. Second driver was the market sentiment which leaned on the gaining view that US Central Bank Fed could be slower with its rate hikes and hawkishness.

–Some of the markets reverted back to their downward trajectory with the gains from the beginning of the month all reversed and others saw a recovery as the month progressed. At the close of the trading day on Oct 25^th the emerging market index MSCI EEM was down-2% on the month and -30% year to date. Yet, the broader equity index MSCI ACWI was in fact up 6% on the month over the same time frame but it remained still in the bear territory with -22% loss year to date.

–Crypto currencies, particularly Bitcoin and Ethereum, gradually inched up throughout the month. On October 25^th Bitcoin closed at $20189 and Ethereum at $1414, but both were still down year to date %56.4 ve %60 respectively. Over the same period most of the developed and emerging market currencies continued their slide against the US dollar.

–DXY index which is the value of US dollar against a weighted composite of Euro, Japanese Yen, British Pound, Canadian dollar, Swedish Krona and Swiss franc, continued to mark its victory in the battle of returns. Despite a weakening by 1.8% earlier in the month as risk asset gained ground, DXY slightly recovered towards the end of the month. However it fell short of its historical peak of 113, though it remained still up on the year with 15.9% and closed at 111 as at the close of October 25^th.

–Turkish stocks continued to be one of only a handful gainers in a jittery market environment, bringing the return on Istanbul 100 stock exchange to 114% in Turkish Lira (a whopping 53% on US dollar basis) year-to-date. The reason for a lower return in US dollar basis was due to declining Turkish Lira against the US dollar. With the US dollar equal to 18.60 Turkish Lira on October 25^st, the greenback gained 39.8% against the Turkish Lira since the end of 2021.

–As Fed continues to raise its benchmark rate to contain inflation, there doesn’t really seem to be any hard stop in sight. This is because the inflation numbers still come in strong, which might be fuelled further by potentially higher crude oil prices going into winter. All the meanwhile the economic growth still seems to be going strong.

–Europe is in no better shape as inflationary pressures have been on the radar of European Central Bank with the looming imminent energy supply issues that continue to pose a threat for the regional economy which we have discussed further in our crude oil markets coverage in this month’s issue.

-Cash is considered king during periods of market drawdowns and heightened volatility. Why? This is because cash is a powerful tool that could be deployed to add to equity and bond positions as well as other dislocated assets during periods of deep drawdowns. Indeed in the current market environment cash is king and will likely remain so if the central banks continue raising their benchmark rates.

–In addition to cash, as we had mentioned before, for retail investors who have the have access to broader global instruments, their portfolios could also benefit from inflation sensitive investments such as inflation linked bonds (such as TIPS in the US), momentum driven strategies and inflation sensitive commodities such as crude oil and gold. The caveat though is that these investments would still be exposed to market volatility and therefore would only be suitable for those investors who can bear such a level of volatility as it is not for the faint of the heart.

–Retail investors could also consider adding assets that tend to do better in high risk and volatility environments such as the DXY, the dollar index, and equity and/or bond volatility indices. The investable universe is broader for institutional investors who can also put on short positions as a hedge and have access to private markets and distressed debt in markets with larger dislocations.

The volatility in the global markets remained high in October on the back of an abundance of risk events throughout the month spanning from record low unemployment data in the US to OPEC+[1] cutting production to the turmoil in UK’s long-term bonds, Gilts, mid-month caused by UK’s overzealous new prime minister Liz Truss that resulted in Truss’ resignation, making her UK’s shortest serving prime minister in history… And the election of the new prime minister Rishi Sunak, all in less than one month…

The markets opened up on a positive note in October with a broad-based rally in risk assets, led by equities. Despite the dire performance of the global equity index MSCI All Country World Index (ACWI) in September which plummeted by 9.3%, October started on a rather positive note with a 5.9% rally in the index on its first two trading days.

TWO MAIN REASONS DRIVING THE MARKETS

Why such a change of heart?

There were two main reasons driving the markets. First, the dip into an oversold territory meant that there were fewer or no market players who could add to their short positions. Hence this was a reaction to the sharp decline in prices. When overextended, markets have a tendency to revert back to where they started.

Second driver was the market sentiment which leaned on the gaining view that US Central Bank Fed could be slower with its rate hikes and hawkishness.

CRYPTO MARKETS BENEFITTED FROM THE POSITIVE SENTIMENT TOO

This risk-on sentiment was broad based with MSCI EEM, the Emerging Market index, gaining 4.95% and the  US 10-year treasury yields which had been on a rise due to inflation fears saw a visible drop from 3.83% to 3.64% over the first couple days of October as well. Crypto markets benefitted from the positive sentiment too with Bitcoin gaining 4.7% moving it to 20,340, above its resistance of 20,000. Ethereum also gained but only 2.2% over the same period.

The positive sentiment in the markets sputtered quickly as inflationary fears returned. It was partially on the back of an expected supply cut by OPEC+, which included 13 member countries and 11 non-member countries that participate in the OPEC cuts and initiatives. At the meeting held on Oct 5^th, OPEC+ agreed to cut 2 million barrel per day in an attempt to support the drop in crude oil prices which had slipped all the way to $79.49 by end of September from over $122 on June 8^th as conflict between Russia and Ukraine continued and markets were concerned about future supply shortages. This production cut, even though was more on paper than in reality, combined with already existing supply concerns going into winter added to the inflation fears given crude oil’s broad use not only by households but also in the industrial context.

UNEMPLOYMENT IN US DROPPED TO ITS LOWEST LEVEL IN HALF A CENTURY

Adding to the volatility and pressure on risk assets was the stronger than expected unemployment in the US which came in at 3.5% on Oct 7^th, the lowest in half a century. This just stoked the concerns that Fed would not slow down with their rate hike. US annualized core CPI, the inflation data that excludes energy and food prices, didn’t help abate these concerns as the data released mid-month revealed that core inflation in the US had climbed to 6.6% higher than the previous reading of 6.3% a month prior.

Markets didn’t take any comfort from the debacle that unfolded in the UK bond market as on September 23^rd UK’s brand new prime minister Liz Truss declared a major tax cut, biggest since 1972, which sent the yields on the long-dated Gilts, UK 30-year bonds, flying to a record 5%, so sending their prices down. As the markets were caught off guard, investors who saw their portfolios draining faster than they had envisioned found themselves selling Gilts to buffer the loss putting further pressure on bond prices. The UK Central bank intervened to support the tanking British Pound and bond prices preventing a vicious cycle which could potentially spill over to not just to other UK assets but to global markets generally. The Central Bank Governor Andrew Bailey had to warn the investors to unwind their positions in short order as the UK Central bank’s mandate was to create market stability and not to support the welfare of its institutional investors on an ongoing basis. This also created a conundrum as the UK Central bank found itself buying the Gilts and therefore unwinding its own monetary tightening This likely means UK Central Bank will now have to deploy higher rate hikes to contain the effect of this unintended monetary easing. In the interim British pound dropped by 5% against the US dollar from 1.126 on September 22 to 1.069 on Sep 24 until the Bank of England intervened which helped the pound to recover to 1.117 by the  end of September and to 1.147 at the end of October 25 after UK identified its new Prime Minister. The currency lost -15.2% year to date.

EMERGING MARKETS INDEX LOST 30 PERCENT

Considering all the doom and gloom, some of the markets reverted back to their downward trajectory with the gains from the beginning of the month all reversed and others saw a recovery as the month progressed. At the close of the trading day on Oct 25^th the emerging market index MSCI EEM was down-2% on the month and -30% year to date. Yet, the broader equity index MSCI ACWI was in fact up 6% on the month over the same time frame but it remained still in the bear territory with -22% loss year to date. US 10-year Treasury yields moved back up to 4.08%. Despite a volatile month , the first month futures contract for WTI held onto most of its gains from earlier in the month. As of October 25^th it was up by 6.9% on the month and 12.9% on the year. Over the same time frame, Gold first month futures contract was only down 0.7% in October and marking a -9.2% loss year to date.

DEVELOPED MARKET CURRENCIES CONTINUED THEIR SLIDE AGAINST THE US DOLLAR

Crypto currencies, particularly Bitcoin and Ethereum, gradually inched up throughout the month. On October 25^th Bitcoin closed at $20189 and Ethereum at $1414, but both were still down year to date %56.4 ve %60 respectively. Over the same period most of the developed and emerging market currencies continued their slide against the US dollar. DXY index which is the value of US dollar against a weighted composite of Euro, Japanese Yen, British Pound, Canadian dollar, Swedish Krona and Swiss franc, continued to mark its victory in the battle of returns. Despite a weakening by 1.8% earlier in the month as risk asset gained ground, DXY slightly recovered towards the end of the month. However it fell short of its historical peak of 113, though it remained still up on the year with 15.9% and closed at 111 as at the close of October 25^th.

ISTANBUL 100 STOCK EXCHANGE GAINED 114% YEAR TO DATE

Despite some instability in September, Turkish stocks continued to be one of only a handful gainers in a jittery market environment, bringing the return on Istanbul 100 stock exchange to 114% in Turkish Lira (a whopping 53% on US dollar basis) year-to-date. The reason for a lower return in US dollar basis was due to declining Turkish Lira against the US dollar. With the US dollar equal to 18.60 Turkish Lira on October 25^st, the greenback gained 39.8% against the Turkish Lira since the end of 2021.

WE ARE NO WAY NEAR THE BOTTOM OF THE MARKET

As we discussed in our last month issue, the current market environment continues to be different than the normal market conditions. While in normal market conditions most traditional investments would have varying correlations, i.e. the extent of the co-movement of two assets in the same direction, amongst each other, since the onset of the equity market turbulence in late December 2021, assets seem to be moving in tandem regardless of their type or geography. As we had explained, this is called converging correlations which tends to happen in explicit risk-off environments and prevents the portfolios from functioning properly as diversification drops considerably. Hence this triggers losses in traditional portfolios as it becomes rather hard to find investments or assets that don’t move with the markets. While October was a mixed bag in terms of magnitude and sign of returns, year to date numbers suggest that the markets have still been moving in tandem overall.

It is hard to predict how effective the central bank policies will be going forward and what will it take to break this cycle of pessimism and downward moves in risk assets.

One thing remains clear though – we are still no way near the bottom of the market and this could get uglier.

HOW FAR COULD THE FINANCIAL CRISIS CONTINUE?

The main question on everyone’s mind is not whether this is a financial crisis or not, but rather how far could it continue and what will be the damage? As Fed continues to raise its benchmark rate to contain inflation, there doesn’t really seem to be any hard stop in sight. This is because the inflation numbers still come in strong, which might be fuelled further by potentially higher crude oil prices going into winter. All the meanwhile the economic growth still seems to be going strong.

But is it really?

October was the month of earning reports in the US and while many of the earnings seemed to be higher than expectations, the companies united on one front; they told the markets “cut your forecasts!”. Why? Because higher interest rates will mean growth forecasts will be discounted at higher rates, which means in today’s numbers they will be lower. Also, because of higher rates cost of capital is expected to be higher leading to lower profitability margins. What does that mean for the broader markets? It means more pain for the equities and risk assets given equities are driven more by future expectations as opposed to current numbers.

INFLATION FIGHT THREATENS GLOBAL GROWTH

Europe is in no better shape as inflationary pressures have been on the radar of European Central Bank with the looming imminent energy supply issues that continue to pose a threat for the regional economy which we have discussed further in our crude oil markets coverage in this month’s issue.

This is not a contained problem either; in late September International Monetary Fund (“IMF”) Chief cautioned that “inflation fight threatens global growth” while the World Bank warned of a “global slump triggered by soaring rates”. In fact, about 90 central banks have raised interest rates this year and half of them have hiked by at least 75 basis points in one shot[2]. In other words there is a global monetary tightening. Then it is impossible not to expect a slowdown in global growth. Indeed, in its World Economic Outlook published on October 17, IMF noted[3] that the “global growth is forecast to slow from 6.0 percent in 2021 to 3.2 percent in 2022 and 2.7 percent in 2023” and “this is the weakest growth profile since 2001 except for the global financial crisis and the acute phase of the COVID-19 pandemic.”

COULD FED CONTINUE TO HIKE FURTHER:

Questions and theories  are abundant as to what might transpire over the next quarter to next year in risk assets such as equities; for instance could SP500 could lose another fifth of its value before the downturn is over? Is it possible the Fed may not stop at its previously designated 4.5% target rate and continue to hike further? Is recession now guaranteed? Many market participants say yes to most or all these questions. These are expectations gaining increasingly more traction than before, and so does the possibility that US 10-year Treasury yields could rise to 6% and beyond while crude oil could see $100 and perhaps way above that once again.

We previously discussed that it is impossible to escape such widespread financial risk periods. But is it possible to create a line of defense in investor portfolios through diversification? The answer is a solid yes, but it is not easy. The reason is what has worked historically may not work in the current market environment. This considerably constricts the investable universe, particularly for individuals as opposed to institutional investors. And the markets are now facing a new paradigm; rising rates and rising inflation which means owning both bonds and equities can just double up the pain. While removing equity and bond exposure altogether may not be wise given the long term positive expected returns in equities and yields on bonds, it may make sense to reduce the exposure to both in favor of some cash which is an asset in its own right and should be deployed judiciously.

CASH IS KING AND WILL LIKELY REMAIN SO

Cash is considered king during periods of market drawdowns and heightened volatility. Why? This is because cash is a powerful tool that could be deployed to add to equity and bond positions as well as other dislocated assets during periods of deep drawdowns. Indeed in the current market environment cash is king and will likely remain so if the central banks continue raising their benchmark rates.

In addition to cash, as we had mentioned before, for retail investors who have the have access to broader global instruments, their portfolios could also benefit from inflation sensitive investments such as inflation linked bonds (such as TIPS in the US), momentum driven strategies and inflation sensitive commodities such as crude oil and gold. The caveat though is that these investments would still be exposed to market volatility and therefore would only be suitable for those investors who can bear such a level of volatility as it is not for the faint of the heart. Retail investors could also consider adding assets that tend to do better in high risk and volatility environments such as the DXY, the dollar index, and equity and/or bond volatility indices. The investable universe is broader for institutional investors who can also put on short positions as a hedge and have access to private markets and distressed debt in markets with larger dislocations.

MARKETS COULD STAY IRRATIONAL LONGER THAN YOU CAN REMAIN SOLVENT

Regardless of the route taken, it will be a painful road ahead for the average investor. It is impossible to guess how the markets will unfold over the next period not only because of the known unknowns but also because of the unknown unknowns. Therefore, short of a crystal ball, it is a moot exercise trying to guess the path of the markets or the asset classes but one can always sleep sound at night knowing for every loser there is at least one winner in their portfolio. As the famous economist John Maynard Keynes said markets could stay irrational longer than you can remain solvent. Hence the goal is not to be fully correct, it is just trying not to be fully incorrect.

Ela Karahasanoglu, MBA, CFA, CAIA

International Finance and Investments Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrtotalportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/

Ela Karahasanoglu is the CEO of EKR Total Portfolio Advisory based in Toronto, Canada. EKR advises global
institutional investors and asset managers on alternative investment and portfolio construction from a total
portfolio perspective. Previously, Ela was the Head of Total Fund Management team at BCI, one of the
largest asset managers in US and Canada with assets over $200 billion.
Ela has over 25 years of international investments and executive leadership experience. She has worked
with global asset management, consulting and pension fund companies in London, New York and Toronto
including UBS, Merrill Lynch, Mercer, CIBC Asset Management and BCI. Ela is a frequent speaker and a
globally published investment thought leader in institutional asset management. Amongst the awards she
has received includes the “Global Leading Innovator” in 2020 and “Hedge Fund Rising Star” in 2018 by The
Institutional Investor, one of the leading publications in the institutional investment field.
Ela is a graduate of Uskudar American Academy in Turkey and has earned her MBA from Georgetown
University in 2000. She has been a CFA Charterholder since 2002 and a CAIA Charterholder since 2010. Ela
serves as the Co-Head for CAIA’s Toronto Chapter since 2018. She is married and lives in Toronto.

[1] The Organization of the Petroleum Exporting Countries (OPEC) was founded in Baghdad, Iraq, with the signing of an agreement in September 1960 by five founding countries Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia, Venezuela and eight other countries who joined afterwards Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Gabon (1975), Angola (2007), Equatorial Guinea (2017) and Congo (2018).  A number of non-OPEC member countries also participate in the organisation’s initiatives such as voluntary supply cuts in order to further bind policy objectives between OPEC and non-OPEC members. This loose grouping of countries, known as OPEC+ includes Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, the Philippines, Russia, South Sudan and Sudan. Source www.opec.org

[2] Source Bloomberg

[3] IMF World Economic Outlook, October 17, 2022 https://www.imf.org/en/Publications/WEO/Issues/2022/10/11/world-economic-outlook-october-2022