While things began to change in October, it was the U.S. presidential election on November 8 that really triggered a rather sudden and sharp increase in the U.S. 10-year yield. Is this the bottom for Treasury yields and the beginning of a steady increase in yields? It is too early to tell. However, it is a good example of how a trend can form based on new fundamental information.
If interest rates continue to rise in 2017, long positions in bonds will be challenged, and portfolios that have the ability to go short bonds may have an advantage in such an environment. Investors have benefited from a strong 30-year cyclical decline in interest rates; however, that will probably not be the wind at their backs in 2017 as it has been in recent history, and instead, it could potentially be a strong headwind.
Rising equity risk and volatility. At AlphaSimplex, we have our own measure of downside equity risk called the Downside Risk Index (DRI).* Currently, that measure for global equity risk is elevated, above average, although not at extreme levels for international and emerging market stocks, and about average for U.S. stocks. This may seem counter-intuitive given that stocks have delivered modest gains so far this year and since there was not an extreme negative market reaction to the U.S. election results.
As we look back at 2016, the first quarter was a roller coaster ride for stocks as the world became concerned about the slowdown in China's growth. While almost a year has passed, it is fair to say the health of the Chinese economy continues to be a global risk with a new wildcard, which is the direction of the United States and China trade relations. We also had concerns about the European recovery, complicated in part by the complexity of immigration and a refugee crisis. And let's not forget the Brexit vote, which, similar to the U.S. election, added a pint of uncertainty to the world order.
Volatility of regulatory change. We often talk about the volatility of stocks, and we are typically referring to the standard deviations of returns over some period (e.g., a month, a year). We have a mathematically defined measure of volatility for stocks, which allows us to have a reference, based on hard numbers that we can compare to historical averages to know when volatility is high or low. While we do not have any such measure of the volatility of regulatory change, I think it is fair to say that if we did, it just spiked to extreme levels.
There are a number of regulatory changes that have been implemented during the Obama administration and many that were far along the regulatory pipeline. This includes everything from big financial regulations, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, to broader regulations that have financial impacts, such as the Patient Protection and Affordable Care Act (ObamaCare), to the Securities and Exchange Commission (SEC) proposal on derivatives and the new liquidity rule, as well as Department of Labor rules on fiduciary standards. Will these regulations be repealed and replaced by the Trump administration? Will they just be tweaked a bit? Will some just die a quiet death in the rule-making process? Will one be implemented only to trigger the elimination of two more regulations?
It is too soon to know for certain. However, as the new administration begins to fill open positions, such as SEC commissioners and Treasury Secretary, each new bit of information will lead to speculation – some of which may indicate change, and some of which may signal less change than anticipated. This juxtaposition is something that I think we have learned is part of the Trump style. This speculation back and forth, and the implications on the markets, is what I would define as Regulatory Volatility (or “RegVol”), and I would say it has never been higher.
Duncan Wilkinson, CFA®, is the Chief Executive Officer at AlphaSimplex
He joined the firm as CEO in 2014 and oversees the business activities and strategic direction of the alternatives investment firm. Duncan has served as a member of the AlphaSimplex Board of Directors since 2007. Prior to 2014, he was Director of U.S. Affiliates for Natixis Global Asset Management. Joining Natixis in 2000, he has held positions of controller, global treasurer, and deputy global chief financial officer. Before that Duncan was a senior manager with PricewaterhouseCoopers, LLP. He holds a BA from Brown University and an MBA from Boston University. He is a CFA® charter holder.