We are in the middle of another market downturn

Ela Karahasanoğlu

-The US Central Bank, FED, moved forward with its hawkish tone on September 21^st and delivered its third 75 bps hike bringing their official central bank rate to 3.25% as widely expected by the market. What really riled the markets up was FED’s view that there was still some ways to go before inflation would abate and the fact that on September 13^th US core inflation number had come in higher than expected at 6.3% on a year-on-year basis. This combo sent the 10-year Treasury yields shooting up to 3.75% before closing at 3.68% by the end of the week on September 23^rd.

-Turkish stock market was one of only a handful gainers throughout a broad-based sell off, bringing the return on Istanbul 100 stock exchange to 76.6% in Turkish Lira (27.6% on US dollar basis) year-to-date on the back of declining Turkish Lira against the US dollar. With the US dollar equal to 18.4 Turkish Lira on September 23^rd, Turkish Lira marked a 38.5% loss in value against the greenback since the end of 2021.

-Commodities suffered from the broad risk off sentiment with NYMEX WTI first month futures contract, the New York based benchmark for crude oil, dropping by 7.5% from $85.1 to $78.7 in just one week where 5.7% of the loss was on September 23^rd, the last trading day of the week, on the back of fears of recession and reduced demand.

-Crypto currencies, particularly Bitcoin and Ethereum, couldn’t escape the wrath of the equity market rolldown given their correlation to risk assets. On September 23^rd Bitcoin dropped to $18852 and Ethereum $1300 at the close of the week after failing to maintain their well-defended support lines at $20000 and $1400 respectively. Over the same period currencies were also in the red with most of the developed and emerging market currencies sliding against the US dollar.

-While equity exposure is beneficial in the long run, during periods of heightened financial stress, such portfolios could experience extended losses in the absence of risk mitigating investments that tend to produce gains during negative market environments. These kind of instruments could create a buffer to portfolios that are dominated by traditional financial instruments such as equities.

-As we are in the gulley of a new financial downturn, it may already be late for those investors who are still invested predominantly in equities and bonds. However it is never too late to redesign and rethink the portfolios for the future, as it is not a question of whether there will be another financial downturn, but a question of when.

September 23 marked the end of a rather volatile week in the financial markets with multiple key central bank decisions and some visible and mostly negative market swings in many asset classes ranging from equities to fixed income to commodities to even currencies.

The US Central Bank, FED, moved forward with its hawkish tone on September 21^st and delivered its third 75 bps hike bringing their official central bank rate to 3.25% as widely expected by the market. What really riled the markets up was FED’s view that there was still some ways to go before inflation would abate and the fact that on September 13^th US core inflation number had come in higher than expected at 6.3%  on a year-on-year basis. This combo sent the 10-year Treasury yields shooting up to 3.75% before closing at 3.68% by the end of the week on September 23^rd. Equities also got hit dragging the US SP500 index to -22.5% and MSCI ACWI, the gauge for global equities, to -23.8% year to date, both officially moving back into the “bear market” territory. Bear market is generally defined as losses larger than 20% or more from recent highs. Emerging market equities were also in the bear market territory closing the same week at -25.7% on a year-to-date basis.

ISTANBUL 100 STOCK EXCHANGE GAINED 76.6% YEAR TO DATE

Despite some instability in September, Turkish stock market on the other hand was one of only a handful gainers throughout a broad-based sell off, bringing the return on Istanbul 100 stock exchange to 76.6% in Turkish Lira (27.6% on US dollar basis) year-to-date on the back of declining Turkish Lira against the US dollar. With the US dollar equal to 18.4 Turkish Lira on September 23^rd, Turkish Lira marked a 38.5% loss in value against the greenback since the end of 2021.

Commodities suffered from the broad risk off sentiment with NYMEX WTI first month futures contract, the New York based benchmark for crude oil, dropping by 7.5% from $85.1 to $78.7 in just one week where 5.7% of the loss was on September 23^rd, the last trading day of the week, on the back of fears of recession and reduced demand. Crude oil had hit $123.8 per barrel on March 8^th due to fears of major supply chain disruptions mostly linked to the conflict between Russia and Ukraine. Gold also slid during the same time frame although to a smaller extent, marking a loss of 1.7% in one week with the first month futures contract dropping from $1683.5 to $1655.6 bringing its year-to-date loss to -9.5%.

MOST OF THE DEVELOPED MARKET CURRENCIES SLID AGAINST THE US DOLLAR

Crypto currencies, particularly Bitcoin and Ethereum, couldn’t escape the wrath of the equity market rolldown given their correlation to risk assets. On September 23^rd Bitcoin dropped to $18852 and Ethereum $1300 at the close of the week after failing to maintain their well-defended support lines at $20000 and $1400 respectively. Over the same period currencies were also in the red with most of the developed and emerging market currencies sliding 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, was the clear winner of the risk-off action. DXY gained 18.3% since the beginning of the year by taking the index to 113, a level not seen since June 2002.

IT IS IMPOSSIBLE TO KNOW IF THE MARKETS HAVE FOUND THEIR BOTTOM YET

Why was the week of 19 – 23 September such a volatile and hence an interesting week? It was simply because most traditional investment moved in tandem regardless of their type or geography. In explicit risk-off environments market correlations tend to converge to one. What that means is that when there is a broad systemic market move,  especially one triggered by a risk event, such as the mortgage crisis in 2008 or the Covid pandemic in February 2020, most asset classes and investments tend to move together in the same direction. While markets tend to go to this risk-off mode only a fraction of the time, market moves during such times can be faster, larger and broad based than times when markets are at their normal state. These periods could be short-lived in equities such as the Covid drawdown in February 2020 which lasted roughly 6 months from start to finish or could be more prolonged such as the 2001 dotcom crisis which lasted 46 months or the 2008 global financial crisis that lasted 39 months. It is not clear how long the current market downturn will last. Yet one thing is clear – this downturn promises to be not a short-lived one.

Why?

Because even after 10 months it is impossible to know at this point if the markets have found their bottom yet.

While it is not possible to escape such wide spread financial risk periods, it is possible to create a line of defense in investor portfolios against such periods through diversification and what is called risk mitigating investments. What’s diversification? Let’s first explain that. Diversification is the utilization of different investments that don’t move together or move in tandem as little as possible, thus reducing the fluctuations in portfolio returns. While diversification works great with traditional asset classes, as discussed above, when markets go through a stress period, most traditional investments such as equities, commodities and even bonds, regardless of their country of origin, start moving in tandem and hence the effect of diversification may decline or totally fail.

HOW COULD INVESTORS REDUCE THEIR PORTFOLIO RISK?

For such periods, investors could consider adding financial instruments that are geared towards mitigating risk to their portfolios.

While equity exposure is beneficial in the long run, during periods of heightened financial stress, such portfolios could experience extended losses in the absence of risk mitigating investments that tend to produce gains during negative market environments. These kind of instruments could create a buffer to portfolios that are dominated by traditional financial instruments such as equities.  One great example is US dollar index, DXY, as discussed above. DXY traditionally has provided protection during risk off environments including the current market downturn given it is considered safe haven by global markets. Depending on the market conditions and where it is in the business cycle, there are other protection-oriented investments. Private markets investments such as infrastructure, private equity and real estate are common choices for investors who have the funds and can bear the illiquidity. More liquid investments such as inflation linked bonds , insurance linked  securities and divergent strategies such as macro and trend following amongst others can also offer a level of buffer. The only caveat is such investments could underperform equities when equities are strong, which is a sacrifice to be made to mitigate the risk of extended portfolio losses which are sometimes rather difficult to recover from. For example, a 50% loss in a portfolio (i.e. losing $50 on a $100 value portfolio) requires a 100% return to recover from that loss which makes the mitigation of such losses more critical than harvesting returns in general.

NOT A QUESTION OF WHETHER THERE WILL BE ANOTHER FINANCIAL DOWNTURN, BUT A QUESTION OF WHEN

While equities and bonds have historically formed the cornerstone of many portfolios given their long-term performance, the toolkit for investors has expanded visibly over the last couple decades. This is due to the increase in utilization of derivatives and increased ability of more investors to access the financial markets. This has led to a much wider variety of traditional and alternative investments which are accessible not only to institutional but also to retail investors and can help deliver returns with lower fluctuations and better protection in down markets. As we are in the gulley of a new financial downturn, it may already be late for those investors who are still invested predominantly in equities and bonds. However it is never too late to redesign and rethink the portfolios for the future, as it is not a question of whether there will be another financial downturn, but a question of when.

Ela Karahasanoğlu, MBA, CFA, CAIA

karahasanoglu@turcomoney.com