Aside from risk defined as permanent loss of capital through default or confiscation, the common measure of risk across instruments or sectors in financial markets has been volatility. Volatility is expressed as the standard deviation of returns over a set period. The higher the volatility measure, the higher the estimated risk but also the higher future, expected return estimates. Making use of this definition as the only standard and widespread notion of risk might lead to tunnel vision. As markets are confronted with geopolitical, health, monetary, fiscal and supply-demand uncertainty, it can pay to enlarge your scope and include maximum drawdown risk in your overall risk assessment.
Maximum drawdown risk for an asset is its greatest historical peak-to-trough decline in value. Imagine that an investor bought heavily into equity over Q4 2021. A worst-case scenario is unfolding as we speak, as selling now would lock in a burdensome loss. Yet, again, it requires courage to look deep into the past in order to face maximum drawdowns that far outpace the current correction. Equity bear markets are defined the moment peak-to-trough adjustments exceed 20%. The Dow Jones average counts 33 bear markets between 1900 and today. The last memorable bear market on the Dow Jones took place between October 2007 and March 2009, dropping 54% peak-to-trough. Bear markets in fixed income do not have a standard definition. However, looking at the iShares 20-year+ US Treasuries index, which reached a high on August 4, 2020, we observe a brutal adjustment of 33.75% by May 6, 2022. The iShares 5 to 10-year US Investment Grade Corporate bond index adjusted by 16.60% between the end of 2020 and May 6, 2022.
When investing during stressful moments, it serves to know one’s market history. Try not to fall victim to panic or subjective argumentation supporting your decision-making. Post-WWII, taking US large-cap stocks as our guide, maximum drawdowns ranged between -54% and -22%, averaging about -34%. Historically, recovery times have fluctuated between 16 months (from 1961 peak) and 74 months (from 2000 peak). On average the recovery in US large-cap equity markets took about 39 months.
In bond markets, we are going through the worst maximum drawdowns on record as we have to go back to 1980 to witness similar adjustments. The key difference in fixed income between today and back then is that recovery times will take longer. Indeed, with a starting point on 30-year US rates at around 1.20% back in August 2020 versus 3.07% today you get the picture looking at a peak some 33% higher. Luckily, with diversification across bond sectors and interest rate sensitivity, on average between 5% and 7%, the outcome for the average bond investor becomes a little less pessimistic.
The 15% adjustment for a quality US corporate fund will require about 2.75 years to fully recover, supposing the bottom was reached in early May, with an expected return for the sector that has climbed towards 5.36%. For European EMU government bond investors, the peak-to-trough takes us from December 11, 2020 till again May 6, for a 13.6% adjustment. In EU IG corporate bonds, the drawdown sits at 11% from August 5, 2021 till May 6. Both sectors have seen their expected returns (mainly carry + roll-down return) rise markedly towards 2.37% and 3.13%. That, again assuming with a big question mark that we have observed the trough, means a recovery time of around 6 years and 3.5 years. Effectively, active management, allowing for proper realisation of higher carry, adjusted for security volatility, might shorten recovery times in a pronounced fashion.
But what if we fall into an inflationary era that impacts expected returns? What if risk premia need to rise further and respective troughs across equity and bond markets have not run their full course? At that moment, it serves well to look at asset classes that protect portfolios. Most balanced portfolios will suffer more as we accept that bond and equity markets become positively correlated. Diversification efficiency between the two drops heavily. In order to protect capital, short to intermediate inflation-linked bonds appear to stand out. Next to short term US Treasuries, we notice that Chinese short-term local currency Renminbi government bonds protect well. Another capital protection instrument often forgotten appears in FX allocation. Not FX allocation in order to grasp short or even medium-term improved portfolio diversification but onboarding, investing long-term in deeply undervalued currencies based on trade weighted exchange rate valuations. The Japanese Yen and Chinese Renminbi appear on the radar. Currently the USD posts a strong rally as uncertainty and rising rates turn leveraged and even unleveraged USD borrowers in a high state of anxiety. Once that fades over the coming years, we might have to prepare for weaker USD episodes, as rate differentials stabilise and long-term trade weighted exchange rate valuations expose the USD as richly valued…
The Chinese monetary authorities, notwithstanding the Yuan weakness these past couple of months, will steer for predictability and a stable Chinese currency as it vies for reserve currency status. The Yen might also get renewed interest under conditions that see the Bank of Japan forced to change tack and let loose on their yield curve control policy. The above exposures do not require to add a lot of duration risk but might render your portfolio increasingly anti-fragile. To that extent, adding gold might also do the trick as the long duration asset class par excellence. Indeed, not mentioning the current short-term weakness, one should not weigh the value of gold over these unimpressive short-term corrective moves. Proper assessment requires one to look at the relative performance robustness of gold versus US rates and other risky asset classes. On a relative basis, gold truly shines these days!
The messages today might make one pessimistic. Do not succumb to this sentiment. The purpose of this brief note has been to confront the reader with reality and potential outcomes based on market history. Knowledge of asset classes requires knowledge of maximum drawdowns and recovery times. Only then, an informed investor stands a chance of achieving long-term real capital growth.
