Model portfolio update: volatility returns

Our model portfolio is up 10.2% year-to-date (to 30 September 2016), during a month where volatility came back to markets. By Todd James

September was a somewhat difficult month to navigate. There were a lot of cross-currents: positive news in the oil markets, negative news in the financial sector, rate-hike uncertainty, mixed economic data and a volatile presidential race.

As a result, after a quiet August, volatility returned to the market in September. 

Our model portfolio ended the month on a positive note, up 39 basis points for the month and +10.2% YTD (to 30 September 2016).    

The small gain doesn’t truly reflect the volatility during the month. After reaching a peak of +11.03% in early September, the portfolio fell 3% within a few days on the back of rate-hike uncertainty before recovering most of the losses by the end of the month.  

Performance drivers

For the month of September, the average ETF in the portfolio was up 0.37%.

The modest gains were led by commodities (after a pull-back in August) and global equities.

Real estate and long-term bonds were hit by the uncertainty and volatility caused by the US Federal Reserve (Fed).

The 10-year US Treasury didn’t move much over the month (from 1.602% to 1.594% at month end) but again that doesn’t reflect the true volatility we experienced.

Emerging markets (EM) continue to move further into positive territory with a gain of 2.2% in the EM equities and a 0.4% gain in EM bonds.  

So what’s ahead? That’s the bigger question. Things continue to look positive. There should be no “when, will, won’t they” talk about the Fed’s rate hike. But it seems it has painted itself into a corner with a rate hike in December.  So this story is on hold until later in November.

Between now and then, we have a US presidential election, and while Clinton appears to be gaining on Trump, anything can happen.

The market appears to have priced in a Clinton victory and that should keep the markets positive at least in the short run.

But regardless of what happens, I would prepare myself for election night; don’t be overly exposed to risk and equities because a Trump victory could do more damage than a Clinton victory would help.

Uncertainty

While the outlook appears relatively positive – or, at least, not negative – there is still the uncertainty caused by the fine imposed on Deutsche Bank by the US Justice Department.

The firm’s shares plummeted after receiving a USD14 billion claim to settle a probe into its sale of residential mortgage-backed securities.  

To put this in perspective, the market cap of Deutsche Bank is around USD15 billion; and don’t forget earlier this year, the equities markets dropped significantly on the rumours that the same bank (among others) may not be able to pay the interest on some underlying debt.

I do not believe it will turn out to be a Bear Stearns or Lehman Brothers-type of event, but it must be monitored with care. If nothing else, it should keep some uncertainty (aka volatility) in the markets while Deutsche Bank negotiates some sort of deal.

Fundamentally, earning estimates remain weak, but not as weak as we have seen over the past year.

The biggest drag on US earnings has been in the energy sector, so any recovery and stability in oil prices will be welcome news for the market as a whole.

It is possible we will see more positive estimates on the earnings front over the last quarter, which could give the markets the solid foundation it is looking for, even if that foundation is built on ‘popsicle sticks’.  

Let us not forget there are general concerns over the bond markets. Many experts talk about an implosion in the bond market because of ultra-low yields but until we see a significant move in inflation. I don’t see it; but keep an eye on the 10-year US Treasury (1.60%) and the CPI index for any signs of life.

In short, it continues to be a good year to be a passive investor. There are a few bumps along the road but that is always to be expected.

Historically speaking, November and December are the best months for equities and while historical returns may not necessary reflect future returns, at least it’s a positive path to follow.