December 2016
Time for a Complete 180
Resolve to Make Yourself Uncomfortable
by Michael Arone, CFA, Chief Investment
Strategist US SPDR Business State Street
Global Advisors
“A man cannot be comfortable without
his own approval.”
— Mark Twain
Joy to the world! In addition to ushering in celebrations with
family and friends, the holiday season brings a flurry of annual
superlative lists — Billboard’s Hot 100 Songs, ESPN’s Top Plays
of the Year along with the more eagerly anticipated Not Top 10
and Barbara Walters’ 10 Most Fascinating People. And, oh what
a year 2016 has been. Perhaps the best way to describe it is as
the year of the long shots! Leicester City won the English
Premier League championship. Citizens in the United Kingdom
voted to exit the European Union, so-called Brexit. The Chicago
Cubs broke a 108-year-old curse and finally won the World
Series. And businessman extraordinaire and reality TV star
Donald Trump was elected to be the next president of the
United States.
The markets also held plenty of surprises. For example, at the
beginning of this year most believed that emerging markets
would continue 2015’s struggle. Yet both emerging markets
stocks and bonds have performed well this year. Another
widely-held view was that gold had lost its luster. However,
gold has glittered for investors in 2016. Lastly, between the
Third Avenue fund meltdown in December 2015 and January
2016’s panic that plummeting oil prices would result in a surge
in energy sector defaults, investors felt confident shunning high
yield bonds. However, portfolios without exposure to high yield
bonds certainly missed out on solid investment performance
this year. (See Figure 1.)
Figure 1: Bond Returns, Year-to-Date as of December 5, 2016
%
20
15.3
15
8.6
10
5.4
5
0
2.8
2.5
2.4
1.6
1.1
Bloomberg Barclays
US Corporate High
Yield Index
Bloomberg Barclays
EM USD Aggregate
Index
Bloomberg Barclays
US Corporate
Index
Bloomberg Barclays
Global Aggregate
Index
Bloomberg Barclays
Global Aggregate:
Government-Related
Index
Bloomberg Barclays
US Aggregate Index
Bloomberg Barclays
US MBS Index
Bloomberg Barclays
US Treasury Index
US High Yield
EM USD Aggregate
US Corporate
Global Aggregate
US GovernmentRelated
US Aggregate
US MBS
US Treasury
Source: Bloomberg Finance L.P., SSGA, December 5, 2016
Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses
associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any
particular fund..
Time for a Complete 180 Resolve to Make Yourself Uncomfortable
Survey Says ...
What, Me Worry?
At State Street Global Advisors (SSGA), we have our own
best-of lists. In fact, twice a year we survey our financial
advisor clients to learn about their top investment concerns
for the next six months and how they are building portfolios.
Our clients’ responses help us determine how we can partner
with them to find solutions to their clients’ toughest challenges.
This November, looking out over the first six months of 2017,
nearly 850 advisors1 listed the following as their top concerns:
What interests me more than these top-of-mind concerns
are the underdog worries. The bottom three concerns cited
by financial advisors for the first half of 2017 were:
1. Rising market volatility
2. The US earnings recession and its potential to result in
an economic recession
3. US political gridlock
I agree with our survey respondents. Volatility is likely to
be higher in 2017, earnings need to improve to support
higher stock prices and the new administration needs
careful watching. But none of this is news. All these worries
permeated 2016. Measures of market volatility rose and fell
according to the daily poll results for the US presidential
election. US companies suffered through an earnings recession
that mercifully ended in the third quarter. In addition,
economic data remained mixed, pointing toward continued
underwhelming GDP growth. Lastly, during the craziest run-up
to a US presidential election in history, Washington D.C. was
locked in all-too-familiar gridlock.
Investors’ concerns about volatility may illustrate the recency
bias heuristic, as our survey window in early November was
during a period when we had just experienced rising
volatility. (See Figure 2.)
1. Economic hard landing in China
2. Rising defaults in high yield
3. Hard Brexit
If you think back on how investors reacted to the events at the
root of these fears at the time they occurred, the current blasé
attitude is especially puzzling. When China unexpectedly and
rather crudely devalued its currency in August 2015, global
markets flew into a tailspin. The Third Avenue fund meltdown
in December 2015 caused widespread panic that illiquid high
yield bonds that had grown in issuance due to historically low
yields would wreak havoc on the economy when the credit cycle
turned. And the United Kingdom shocked the world with the
Brexit vote.
Delving more deeply into these significant but
underappreciated risks illustrates why investors’
comfort with these issues makes me uncomfortable:
• Hard Landing in China: Move Along, Nothing to See
Here. China’s surprise devaluation led market participants
to conclude that perhaps reforms to transition the economy
from investment-led to more consumption-led weren’t
working as expected and that Chinese officials were
abandoning them in favor of the old economic growth
stalwart, exports. In response, Chinese officials unloaded
another bazooka of monetary, fiscal and credit stimulus to
Figure 2: Volatility Rose Right Before the US
Presidential Election
Figure 3: Foreign Direct Investment in China Declines
with Currency
VIX Level
CNY/USD
30
0.17
Net Monthly Foreign Direct Investment ($ Billion)
10
5
26
0.16
0
22
-5
0.15
-10
18
10
-15
0.14
14
-20
Dec
2015
— CBOE VIX Index
Feb
2016
Apr
2016
Jun
2016
— 50 Day Moving Average
Aug
2016
— 100 Day Moving Average
Source: Bloomberg Finance L.P., SSGA, December 5, 2016.
State Street Global Advisors
Oct
2016
Dec
2016
0.13
Dec
2011
Oct
2012
Aug
2013
Jun
2014
Apr
2015
Dec
2016
-25
— CNY/USD (LHS) — China Net Monthly Foreign Direct Investment (RHS)
Source: Bloomberg Finance L.P., SSGA, December 5, 2016.
2
Time for a Complete 180 Resolve to Make Yourself Uncomfortable
support their economy. And, after an incredible explosion in
credit growth — some estimates have Chinese debt to GDP at
about 250 percent — things seemed to stabilize.
However, despite policymakers’ restrictions to curtail capital
outflows, reserves continue to plummet. Falling by $69.06
billion in October, reserves have steadily declined over the
last two years to $3.052 trillion, the lowest level in nearly six
years.2 Today, credit-fueled Chinese economic growth
continues to slow. And, because China is the second largest
economy in the world, this poses risks to the global economy.
What’s more, China may face additional challenges from the
tariff-threatening, saber rattling of the new US
administration. (See Figure 3.) Already US President-elect
Trump’s threat to label China a currency manipulator on his
first day in office and his recent telephone call with President
Tsai Ing-wen of Taiwan signal a tougher stand with China.
• Defaults in High Yield: Grossly Exaggerated Fears
Renewed. In hindsight, the Third Avenue fund meltdown
was a small isolated incident in a distressed market, rather
than an indictment of high yield. Also, oil prices stabilized
and defaults in the energy sector never reached the complete
washout the high yield spreads were reflecting. And while
US economic growth has been underwhelming, it’s far from
recession levels. As a result, spreads narrowed and high yield
bonds performed quite well in 2016.
What’s amazing now is that spreads are near historic lows.
The economic expansion is growing older. Interest rates are
rising and for many high yield issuers rolling over their debt
that comes due in the near term is going to be harder and
more expensive. According to Moody’s, a record $947 billion
of US high yield debt is scheduled to mature in the next five
years.3 A US recession is probably nearer in this business
cycle than farther away and we are in the later stages of a
long credit cycle. High yield is priced for perfection with
historically tight spreads at a tenuous time for the economic
expansion, interest rates and inflation. That means the
margin for error in high yield is small. (See Figure 4.) Yet
investors seem to have little concern for these challenges.
• Hard Brexit: The Shot Heard Round the World
Surging populist sentiment was the big surprise in 2016.
The market recovered after the post-Brexit swoon and
despite a lot of political posturing not much has happened.
However, in an early October speech at the Conservative
Party Conference in Birmingham, British Prime Minister
Theresa May promised to enact Article 50 to begin the long
process of Brexit by the end of March 2017. May’s promise to
protect Britain’s borders while still maintaining access to the
single market was a shot across the European Union bow and
not warmly received. Tough talk from Germany and France
is likely to make this an interesting unwind. (See Figure 5.)
State Street Global Advisors
Figure 4: High Yield Spreads Continue to Tighten
OAS (%)
18
14
10
6
Mar
1993
2
Dec
1997
Sep
2002
Jun
2007
Mar
2012
Dec
2016
— Bloomberg Barclays US Corporate High Yield Average OAS
— Long Term Average
— 3 Year Rolling Average
Source: Bloomberg Finance L.P., SSGA, December 5, 2016.
While the UK economy is not large enough to infect the
global economy, Germany and France cannot allow Britain
to limit the free movement of people at its borders while
still reaping the benefits of single market access. Brexit, in
combination with Trump’s victory and eurosceptic elections
in Austria, Italy, Germany, France, and the Netherlands,
will have huge implications for the ability of the European
Union to continue. Odds are rising that the European
Union becomes less integrated and may even break up.
Brexit negotiations will set the tone for the rest of Europe
in the first quarter of 2017 and may be a harbinger of the end
of the euro experiment. That is definitely something to worry
about. When Article 50 gets enacted in the first quarter at a
time with potential for great upheaval in European
leadership, expect more surprises and hard turns.
Figure 5: Global Policy Uncertainty Keeps Moving Higher
Uncertainity Index
300
250
200
150
100
50
0
Jan
1997
May
2001
Oct
2005
— Global Economic Policy Uncertainty Index
Mar
2010
Aug
2014
Sep
2016
— 12 Month Average
Source: Bloomberg Finance L.P., SSGA, December 5, 2016.
3
Time for a Complete 180 Resolve to Make Yourself Uncomfortable
Be a Better Decider in 2017
As we look ahead to the new year, it is also interesting to explore
how risks that once were so top-of-mind and worrisome can
become so accepted. The answer may be decision fatigue.
Behavioral studies show that the more decisions you make
throughout a day, the more difficult each one becomes for your
brain.4 Accordingly, the brain looks for energy-saving mental
shortcuts, and either becomes reckless or simply decides to do
nothing. Multiply that daily fatigue over the course of a year like
we’ve experienced and it’s easy to understand why investors
have pushed big risks to the back burner.
If you think that any of the lower-ranked concerns from our
survey may come to fruition in 2017, consider protecting your
portfolio from tail risk events with risk-mitigating strategies.
Also, in an uncertain market, investors need to sharpen their
decision-making to guard against behavioral biases. Over
the years, when clients have asked for my advice on how to
decide between two or more investment opportunities, I’ve
responded in the following way: For the investment choice you
feel most comfortable with, keep questioning, keep exploring,
keep asking yourself what could go wrong. Be wary that you are
too confident that this is the right choice for your portfolio. For
the investment choice you are least comfortable with, if you’ve
done your homework, go ahead and make the investment.
This surprises some, but some of the best investments are
made with the greatest discomfort. And some of the biggest
investment mistakes have been made with great confidence,
borderline hubris. The coming year will greet investors with
great risks and great opportunities. As 2016 has underscored,
in investing, as in life, the things we feel we have a handle on
often surprise us, while what we worry about rarely impacts
us as much as we fear.
So, if you are looking for a New Year’s resolution, how about
allowing yourself to feel uncomfortable? In addition to helping
you manage risks to your portfolio, being uncomfortable means
you stay curious, welcome new ideas and challenge yourself
to learn.
Discomfort can be the driver of success.
4
Shai Danziger, Jonathan Levav, and Liora Avnaim-Pesso, Extraneous Factors in
Judicial Decisions.http://pnas.org/content/108/17/6889.full.pdf.
Glossary
50-day moving average A popular technical indicator which investors use to
analyze price trends. It is simply a security’s average closing price over the last
50 days.
100-day moving average A popular technical indicator which investors use to
analyze price trends. It is simply a security’s average closing price over the last
100 days.
Bloomberg Barclays Capital High Yield Bond Index A benchmark that includes
all fixed income securities with a maximum quality rating of Ba1/BB+ (including
defaulted issues), a minimum amount outstanding of $100 million, and at least one
year to maturity.
Bloomberg Barclays EM USD Aggregate Index A flagship hard currency
Emerging Markets debt benchmark that includes USD-denominated debt from
sovereign, quasi-sovereign, and corporate EM issuers.
Bloomberg Barclays Global Aggregate Bond Index The Barclays Global
Aggregate Index provides a broad-based measure of the global investmentgrade fixed income markets. The three major components of this index are the
U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate
Indices. The index also includes Eurodollar and Euro-Yen corporate bonds,
Canadian government, agency and corporate securities, and USD investment grade
144A securities.
Bloomberg Barclays Global Aggregate Government-Related Index Represents
the government-related component of the Bloomberg Barclays Global Aggregate
Index, including agency, local authority, sovereign and supranational.
Bloomberg Barclays U.S. Aggregate Bond Index A benchmark that provides
a measure of the performance of the U.S. dollar denominated investment grade
bond market, which includes investment grade government bonds, investment grade
corporate bonds, mortgage pass through securities, commercial mortgage backed
securities and asset backed securities that are publicly for sale in the US.
Bloomberg Barclays U.S. High Yield Corporate Bond Index The Barclays
U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt.
Eurobonds and debt issues from countries designated as emerging markets (sovereign
rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch)
are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG
countries are included. The index includes both corporate and non-corporate sectors.
Bloomberg Barclays U.S. MBS Index A benchmark designed to measure
the performance of the US agency mortgage pass-through segment of the U.S.
investment grade bond market. The term “U.S. agency mortgage pass-through
security” refers to a category of pass-through securities backed by pools of
mortgages and issued by US. government-sponsored agencies.
Bloomberg Barclays U.S. Treasury Index US dollar-denominated, fixed-rate,
nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity
constraint, but are part of a separate Short Treasury Index.
A total of 839 investment professionals completed State Street Global Advisors’
online year-end survey, the goal of which was to determine the investment
concerns and client portfolio considerations that were top-of-mind for investment
professionals. The survey was fielded in November 2016. Respondents represented
a variety of investment professional segments holding a wide range of assets
under management.
Brexit An abbreviation of the term “British Exit,” which refers to the UK referendum
on June 23, 2016, that resulted in the country’s decision to withdraw from the
European Union (EU). Under Article 50 of the EU’s Lisbon Treaty, a country that votes
to leave the common market has 24 months to do so.
2
Kevin Yao, “China November forex reserves fall more than expected to lowest
in nearly six years,” Reuters, December 7, 2016. http://reuters.com/article/
us-china-economy-forex-reserves-idUSKBN13X03N.
3
Ciara Linnane, “Junk-bond market facing record refinancing cliff: Moody’s,
Marketwatch, February 17, 2016. http://marketwatch.com/story/
junk-bond-market-facing-record-refinancing-cliff-moodys-2016-02-16.
Global Economic Policy Uncertainty Index A GDP-weighted average of national
EPU indices for 16 countries: Australia, Brazil, Canada, China, France, Germany,
India, Ireland, Italy, Japan, Russia, South Korea, Spain, the United Kingdom, and the
United States.
1
State Street Global Advisors
CBOE Volatility Index, or VIX A measure of market expectations of near-term
volatility conveyed by S&P 500 stock index option prices.
Gross Domestic Product (GDP) The monetary value of all the finished goods and
services produced within a country’s borders in a specific time period.
4
Time for a Complete 180 Resolve to Make Yourself Uncomfortable
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Important Risk Information
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ID8250-IBG-22159 1216 Exp. Date: 12/31/2017