Stocks slump on geopolitical and economic concerns
A range of concerns about growing instability in the Middle East, weak economic growth in China, and mixed domestic economic data led to a modest sell off in equity markets. The Dow Jones Industrial Average finished down 1.0% and the S&P 500 Index shed 1.4%.
On the plus side, second quarter GDP was revised to 4.6% from an initial estimate of 4.2%. Based on the latest data, the third quarter represented the strongest period of expansion in nearly three years. Underlying trends were strong in a number of areas, including business investment, residential investment, and consumer spending. It is important to remember that weather-related discrepancies likely played a role in the strength of this rebound, and that is a phenomenon that may not continue into the third quarter.
On the housing front, there were several conflicting reports. Existing homes sales declined 1.8% in August to a 5.05 million seasonally adjusted annual rate. The National Association of Realtors indicated that the number of all-cash sales dropped steeply in the month, providing better purchase opportunities for first time homebuyers. At the same time, prices are continuing to rise, up 4.8% on a year-over-year basis to $219,800. Overall inventory available for sale experienced a slight downtrend, but unsold inventory moved incrementally higher.
Consumer sentiment painted a somewhat brighter picture. The final sentiment reading for September was 84.6, up just over 2 points on the month, bolstered by growing confidence for future expectations.
Regulatory changes created some impact on markets, specifically around the issue of tax inversion transactions. In short, M&A activity was up quite noticeably this year as U.S. companies were merging with foreign companies, thereby allowing those companies to effectively move to the foreign tax jurisdiction. It is widely believed that this was the result of recent increases to the effective tax rate.
Source: JP Morgan
The U.S. Treasury Department released rules designed to curb tax inversions last week. Specifically, the Treasury made it more challenging for companies to switch tax domicile without having to pay similar effective tax rates. Such changes are likely to slow the pace of M&A, but the rules do not apply to future revenue generation, so there still remains a reason for companies to want to pursue these deals in certain situations.
Will risk parity performance persist?
With risk parity portfolios on the whole having outperformed traditional 60/40 allocations since the trough of the financial crisis, one must be mindful of the risks that lie ahead when determining the efficacy of such an approach.
Looking at performance year-to-date, the Salient Risk Parity Index has outperformed a traditional 60-40 allocation and even broader equity markets by a significant margin. Going back five years, a risk parity approach has outpaced a traditional 60/40 allocation by more than a percent on an annualized basis.
So what does this mean going forward? As the case with all investments, past returns are not indicative of future results.
Salient’s Risk Parity Index is comprised of an equally risk-weighted portfolio of equities, commodities, global interest rates and credit. The Index risk-weights the underlying assets at both the asset class and sub-asset class level and is rebalanced monthly. As is the case with the general approach to risk parity allocation, asset weightings are based on each asset class’ respective historical risk, in which annualized standard deviation is often used to determine such. With fixed income assets running with roughly one-fifth the historical volatility of equities, the asset class by nature is going to be an outsized dollar allocation.
Given historically low interest rates over the preceding decades, it is easy to see why an outsized allocation to the asset class may be problematic on a forward-looking basis.
Looking at performance across the past three months may paint a clearer picture as yields on the U.S. 10-Year Treasury have fluctuated between 2.3% and 2.7%. The Salient Risk Parity Index shed 4.3% during this time while a traditional 60/40 blend gained 1.2%. While commodities trended lower during this same period, it is safe to say that negative performance during this period was due almost entirely to interest rate and credit exposures. Just during the month of September, when the U.S. 10-Year increased from 2.3% and peaked at 2.6%, the Salient Risk Parity Index fell 4.7% (through September 26).
While equally risk-weighted portfolios may seem appropriate on a diversification basis and have resulted in outperformance throughout the past five years, investors must be cognizant of inherent risks that lie ahead, particularly within fixed income markets.
The week ahead
The end of the quarter brings a full economic schedule, ranging from personal income and spending to nonfarm payrolls. Markets will also focus on ISM manufacturing, ISM nonmanufacturing, Case-Shiller home prices, and balance of trade.
In Europe, the ECB is scheduled to meet this week, but no changes are anticipated given ongoing sluggish economic activity and weak inflation trends.
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