Even though price volatility has eased significantly across all asset classes amid the massive liquidity injections from central banks, the market could experience another little selloff in the near term due to the rising uncertainty coming forward. In addition, we know that most of the risky assets tend to perform poorly in the ‘summer’ period that runs from May to October.
Although some investors may define silver as a risk off asset, we recently saw that the precious metal has performed very poorly during periods of market stress. We think that silver could experience some weakness in the short run, especially now that we are approaching the month of June. In figure 1, we compute the average performance of silver for every month of the year since 1982; interestingly, June has historically been the worst month with silver falling by nearly 2% on average. Time to sell and go away?
Source: Eikon Reuters, RR calculations
One particularity of a safe-haven asset is that it is negatively correlated with the performance of equities during periods of panic and selloffs. For instance, we saw that gold performed strongly in the past two equity selloffs, up 7% in Q4 2018 and 3.5% in Q1 2020 while equities were down by 14% and 20%, respectively. Figure 2 shows that silver did not act as a zero-beta asset and co-moved strongly with equities during the February / March panic. We strongly believe that investors have this chart in mind for the coming months and that a little 10%-15% drawdown in stocks in the near term will certainly lead to a little (bear) consolidation in silver.
Source: Eikon Reuters
Even though some analysts are currently saying that silver looks extremely undervalued relative to gold (gold-silver ratio is still elevated relative to its long-term average), we do not think that the ratio will matter in the near future and we could have another divergence between the two precious metals. Figure 3 (right frame) shows that prior the Covid19 crisis, a surge in gold prices had historically been followed by a surge in silver 3 weeks later since the start of 2015. However, we can notice that the two assets have strongly diverged in the past few months.
In this chart, we look at the performance of US equities relative to Treasuries over time. As you know, price volatility differs among different asset classes; hence, in order to compare the relative performance of equities versus risk-free securities, we need to vol adjust. Using monthly times series of total returns of the Bloomberg Barclays US Aggregate Bond Index and the SP500 index, we calculate monthly returns of each asset class and then adjust our US Treasuries exposure using the 1-year realised volatility of equities. We also rebalance our portfolio every single month so that the volatility of each asset remains constant.
As you can notice, the SP500 index has lost 65% of its value relative to bonds since January 1974, with a high of 77% reached in the last quarter of 2010. Moreover, in the past two economic downturns, equities have lost 20% of their values between 1999 and 2002 and 12% of their value between 2007 and 2009. We saw last year that US 10Y nominal yield topped at 3.25% and struggled to break higher despite a nominal growth close to 6% in the United States. With yield plummeting to 2% in the past 6 months, the bond market is currently pricing in a sharp deceleration of economic activity and some practitioners are expecting rates to fall to zero percent as fear over a 2020 recession have increased dramatically. This raises the following question: should we expect Treasury bonds to significantly outperform US equities once again in the next economic downturn?
Chart. SP500 vs. US Treasuries – Total Return. Source: Bloomberg, Eikon Reuters
Prior the Financial Crisis, the carry trade strategy in the currency market was perceived to be a profitable and generated significant returns for traders seeking for yields. In the appendix A, we show the performance of the carry strategy between 1975 and 2008, along with the performance of equities and fixed income according to a 2008 publication from JP Morgan. We can notice that the funded carry strategy, which invested equally in three currencies with the highest yields funded by borrowing from the three currencies with the lowest yields, outperformed both fixed income and equity returns during that period. According to JPM calculations, if you invested $1 in 1975 in each of the strategy, the initial investment in funded carry grew to $84.16 in early 2008 (vs. $15.25 in fixed income and $51.74 in equities), whilst experiencing volatility levels between those two assets.
However, the situation changed abruptly during the financial crisis when the carry currencies (i.e. AUD) plummeted and funding curries (i.e. JPY) experienced significant appreciation. For instance, if we take the AUDJPY exchange rate as a proxy of the traditional G10 carry trade, we can see in Appendix B that the strategy followed the same pattern as the (US) equity market and hence experienced a sharp correction between July 2008 and March 2009 (AUDJPY was down 45%). Since then, many investors have considered the carry trade strategy to be a risk-on strategy, exhibiting strong co-movements with DM equity markets (hence poor for diversification) and described it as a ‘gradual appreciation punctuated by sudden crashes’ type of behavior (the famous quote: ‘going up by the stairs, and coming down by the elevator’). It is quite usual for an EU/US global macro trader or investor to watch the overnight Yen developments to see if anything major happened in Japan or China for example (strong Yen appreciation usually means bearish macro news for equities).
Even though the co-movement between AUDJPY and US equities (SP500) has been inexistent over the past 5 years, an interesting observation emerges when we overlay the AUDJPY exchange rate with EM equities. As you can see it on the chart, EM equities have moved in tandem with the ‘carry’ exchange rate; the 3M daily realized correlation stands now at 92%. AUDJPY is almost down 10 figures (i.e. 12%) since mid-January, and traded below 79 earlier this month, its lowest level in two years. We will see if the correlation persists in the months to come and if a rebound in the Aussie (or Yen weakness) will benefit to EM equities, which are down more than 25% since January highs.
Chart: AUDJPY vs. EM Equities (Source: Eikon Reuters)
Appendix A: Carry Strategy vs. Equities and FI (Source: JP Morgan)