The major macroeconomic question for the upcoming week is simple: how bad can the bank stress test results in Europe be? Multiple media outlets have speculated that some two dozen major banks may be found to have insufficient capital reserves. In an interview yesterday with Institutional Investor, Robert Savage, the CEO of New York–based hedge fund firm CCTrack Solutions, waxed philosophical about the release. “I believe that the markets are fully prepared for some failures because of the leaks to the media,” he said, adding, “The devil will be in the details.” According to Savage, despite major problems in Europe, the European Central Bank’s asset purchase shifts in the past week have sent a signal that a worst-case scenario may not play out in Europe.
Monday, October 27: IFO sentiment indexes for Germany are scheduled for release. But the primary focus in the Continent for investors will be the ECB September private loan data. With concerns over the stress test looming over European lenders, many analysts have argued that private sector credit has been stymied. In the U.S. a relatively light macro reporting calendar includes pending homes sales and Markit services purchasing managers’ index (PMI) for October. Pharmaceutical firm Merck & Co. is among the large-cap U.S. equities posting results Monday as earnings season rumbles along.
Tuesday, October 28: The U.S. will be the focus for major economic data releases on Tuesday with September durable goods, October Conference Board consumer confidence levels and Case-Shiller August home price levels. Forecasts are for the price of homes to have contracted in late summer despite tightening supply and historically low mortgage rates. On a day full of earnings announcements, Facebook’s quarterly earnings will be in the spotlight for tech investors.
Wednesday, October 29: Wednesday kicks off with September industrial production data from Japan. With strong doubts remaining on Abenomics despite a recent pick-up in international trade, any deviation from the anticipated rebound from August levels will impact yen-denominated markets. The start of the Federal Open Market Committee’s monthly meeting will likely be the primary topic of discussion for the day. Visa will announce quarterly results after U.S. equity markets close on Wednesday, with expectations riding high after a dividend boost announced in advance of earnings.
Thursday, October 30: October employment and consumer price index (CPI) data in Germany and sentiment indexes for the euro zone are on the calendar. As Fed policy continues to be the biggest factor driving asset price fluctuations, data from the U.S. will take center stage, with an FOMC announcement, claims data and preliminary U.S. third-quarter 2014 GDP data on deck.
Friday, October 31: Abenomics will face another test as consumer inflation levels for September are released in Japan. Despite the efforts of policymakers at the Bank of Japan to push upward on price levels, consensus forecasts call from a moderate contraction from August. Later in the day, the Bank of Japan is issuing its monthly policy statement. For the euro zone, October CPI and September unemployment data are on Friday’s schedule, with expectations for moderate improvement for prices and a flat jobs numbers. U.S. September personal consumption expenditures are forecast to show no major shift in activity at the cash register, while University of Michigan U.S. consumer sentiment index levels are expected to moderate slightly for the month. The Anheuser-Busch InBev earnings call will provide investors with insight into the impact of macro factors on global consumer spending.
Portfolio Perspective: Why It’s Best to Replace Core Bond Holdings With Alternative Strategies — Prateek Mehrotra, Endowment Wealth Management
What goes up must come down. Given that the Fed is expected to lift interest rates next year, the rally in Treasuries is on track to reverse. Ten-year Treasury bond prices will dive 9 percent if interest rates rise 1 percent. Should ten-year yields jump 2 percent, Prices will plunge 18 percent. A 3 percent yield increase translates to a 27 percent crash in prices.
Last year, when yields on ten-year Treasuries ticked up 1.18 percentage points, ending the year at 3.04 percent, the iShares 7-10 Year Treasury Bond ETF dropped 6.1 percent in 2013. The Vanguard Extended Duration Treasury ETF, a fund of 20- and 30-year government bonds, crashed 19.9 percent as 30-year Treasury yields climbed 0.92 percentage points to 3.96 percent.
The ten-year Treasury yield is hovering above 2 percent. It can jump more than two percentage points and merely get back to its historic average of 4.63 percent. If a 1 percent uptick in yields gives way to a high single-digit price swoon, a two-percentage-point hike will be very painful.
It’s usually prudent for fixed-income investors to diversify bond exposure across higher-yielding assets, credit risks, currencies, durations and central bank policies with nontraditional, fixed-income assets. But this won’t help avoid losses during bear markets when all non-Treasury assets become highly correlated with the stock market. I thus recommend complementing core bond investments with liquid alternative strategies, especially when fixed-income assets are overpriced as they are now. Such liquid alternative strategies include global macro, long/short and fixed-income arbitrage, which historically had little correlation with the broader market.
Currency long/short — a type of global macro strategy — takes advantage of price gains from the price convergence of two currencies whose prices move independently of their economies. Alternative strategies limit drawdown by letting managers short assets that are vulnerable to sell-offs in times of stress. In other words, they allow asset allocators to “own the bull but hedge the bear.” They offer managers a larger investment universe and greater flexibility to pursue returns across uncorrelated global markets. Given that 95 percent of bond returns during the past decade have come from duration, alternative strategies reduce interest rate exposure, thus lowering correlations with traditional fixed income.
Prateek Mehrotra is CIO of ETF-MS and Endowment Wealth Management, a registered investment adviser in Appleton, Wisconsin.
