Insight on the age of volatility

March 28, 2022

Everything flows, they used to say in Ancient Greece; however the degree of change that we have witnessed in the past months and years, appears to have reached a peak in recent days. The global political and economic order is being shaken up brutally by the war in Ukraine, with what is increasingly being seen as an existential conflict between Western democracies and principles of human rights on the one hand against autocratic models of governance that have been gaining ground in recent years, not only in Russia but in other parts of the world.

For financial markets, geopolitical events have ambiguous effects, some with profound reverberations on a global scale, others merely locally and temporarily impacting stock prices for instance. What the current war in Europe will develop into, not to mention the consequences for investing, is impossible to say. The strain on commodity supply, however, with Russia representing a global commodity superpower being sanctioned heavily, leads to extreme price swings in many commodities in all commodity groups (industrial metals, energy, precious metals, and agricultural commodities) which have a dampening to stifling effect on economic growth. In this “Insight” publication, we however would like to focus onto longer-term processes that will as much drive the prices on financial markets in the coming years. 

The West’s energy dependency

The main reason for even higher volatility on European equity markets compared with the US equity market of course is the geographical proximity to the war zone, but Europe’s high dependence upon Russian energy (crude oil, natural gas) leaves it economically vulnerable to pressure from the East. The sweeping sanctions Russia was placed under may have come as a surprise for some leading figures in the Kremlin, we however note that energy products were largely spared from financing restrictions (such as shutting out only several Russian banks from global payment system’s SWIFT network), in order not to stop the flow of carbohydrates to Europe.

But the US, despite it having doubled domestic crude oil production over the past decade, still imports to the tune of several million barrels of crude per day, leaving its economy vulnerable to an oil price shock as well. The dependence on imports from abroad appears to continue, adding to the pressure on the current, “greener” US administration which reins in shale oil & gas production on the grounds of environmental protection.

Crude oil price (Brent)

The latest geopolitical crisis has once more brutally demonstrated how interdependent the world has become and that turning the West’s back on Russia, however merited on the grounds of universal human rights, comes with grave consequences in the realm of commodity prices.

Temporary on which time scale?

After the biggest economic shock since WW2 in the form of the Covid pandemic, many pundits were convinced of a temporary spike in inflation, due to all of those bottlenecks and disrupted supply chains in connection with the pandemic. According to the “summary of economic projections” by members of the Federal Open Market Committee (FOMC), the Fed’s rates setting body, they on average estimated the 2021 core inflation to be 1.8%. The data for December 2021, published in late January of this year, came out at a whopping 4.9% year-over-year.

Consensus forecast for US PCE inflation in 2022

For the current year’s PCE inflation forecast, consensus estimates have risen by almost 100% since mid-2021. Now, we have a complicating factor: war times typically are highly inflationary. Looking at the development of many commodity prices in the few weeks since Russia’s aggression on Ukraine started, it is fair to assume that inflation will most likely further accelerate before it starts to come down. This leaves central banks with a dilemma. The current spike in commodity prices, from industrial metals to agricultural commodities, will feed through to consumer prices, at a time where price pressures are already hardening the lives of many. Price stability in danger, put differently.

That darn punch bowl

The current geopolitically turbulent times provide wiggle room for central banks, as they now focus strongly on systemic stability, meaning they are much more likely to provide liquidity to markets. This, in other words, means that the proverbial punch bowl will not be taken away anytime soon. We can discern two main conclusions from such a scenario: First, moral hazard continues, i.e. the fact that many market participants incur levels of risk that they alone cannot bear in an adverse environment, but still do because they expect to be saved by someone else, such as the government in general or the central bank in specific. Moral hazard means a continuation of levering up the economy. Second, whenever the time will come, the shock provided by aggressively slamming on the monetary brakes by major central banks (cf. the “Volcker shock” of 1979/80) may well be expected to be brutal – just not in the coming months.

Balance sheet total (USD bn): Fed, ECB, PBoC, BoJ, SNB

We live on borrowed times, in other words, as today’s turmoil will give central banks a good excuse to continue with their accommodative policies. The ECB’s announcement in its March meeting that it will be cautious with its taking back monetary stimulus to us was but the first acknowledgement of central banks willing to err on the side of caution when it comes to “normalize” monetary policy.

Reversion to the mean?

The liquidity of central banks in the past decade acted as a tailwind for financial assets, with many economists using the term “asset inflation” describing the valuation expansion that took place since the global financial crisis (GFC) of 2008/09.

A good measure of overvaluation is the so-called Shiller-P/E or cyclically-adjusted price-to-earnings ration (CAPE). While not helping much with timing the market, as this gauge depicts the ratio of current stock price levels to the average inflation-adjusted earnings of the previous 10 years, its long-run forecasting capability is astounding. From a long-term perspective, the observation is striking that the subsequent 10-year inflation-adjusted total returns for stocks (including dividends) is very closely aligned to Shiller-P/E-based valuations.

CAPE and 10-year average stock returns

Looking at today’s CAPE level which just has reached the second-highest level in over 130 years, the long-term prospects for equity investors are very bleak. Current levels would hint at losses on an inflation-adjusted basis for the coming 10-year period in the order of 40% in cumulative real terms.

We would like to emphasize that we do not suggest to our clients that they fully abstain from equities for the coming decade. The most negative 10-year real total return period in the S&P 500 was from March 1999 until March 2009 – almost -6% on an annualized basis. However, there were another 12 months of strong gains of +25% that started in March 1999. Main reason for this 10-year period being the most negative for investors was of course the steep drop of equity prices in the GFC into March 2009 – or put differently, the period of March 1999 to March 2000 displayed a lower 12-month return than that from March 2009 to March 2010 (+46%  – all data on a month-end basis). Therefore, it may not be overly helpful for an investor to decide to enter a 10-year hibernation period when it comes to investing in equities. This argument may be further underlined by stating the fact that the S&P 500 doubled from March 2003 until October 2007.

S&P 500 Index: 1998-2010

Buy and hold – for some time

To us, these findings call for a different approach to investing: actively steering the exposure to the different asset classes, with sufficient liquidity levels to be kept for deployment during times of strong stock market losses and a disciplined approach to taking profits.

A more active investment approach does not only apply to equities, but also bonds, commodities, and digital assets (with their recurring „crypto winters“, i.e. up to two years of devastating bear markets). While we consider fixed income securities in general to be very unattractive, there are some segments in the asset class that at least compensate to a certain degree for the risk they bear, compared to government bonds in the West with a very asymmetrical risk/return profile. However, on a ten-year horizon, chances are high that at one point in the coming years, rising yield levels will have reached a point where investing in investment grade bonds once again is promising – unlike today.

The same holds true for the commodities asset class. Pork cycles are quite well-known, but similar patterns exist in other, also non-livestock commodities, if maybe at less stable frequencies compared to the former. At times where commodity prices are skyrocketing again, with several industrial metals at all-time highs, the prospect of those prices ever coming down again appears remote. Any person with sufficient experience in the commodities markets will however state that every price rally ended, and the steeper the rises had been, the deeper the subsequent falls turned out. As a consequence, „buy & hold“ is not the suggested strategy in commodity investing.

Bloomberg Commodity Index long-term

Hedge funds coming to the rescue

During the aftermath of the dotcom bubble bursting, hedge funds (HF) stepped into the limelight as they had provided their investors with a lot more stable (and positive) returns than the traditional asset classes (apart from government bonds, that is). Hedge fund assets under management (AuM) doubled from Q4 2000 to Q2 2003, at a time when equity markets about halved. The following +450% growth until mid-2008 in HF industry AuM is testament for an immense growth in demand for agile investment strategies that seemingly produced positive returns irrespective of the environment, be it a bull or a bear market.

Hedge fund industry AuM (USD bn)

Unfortunately, as investors had to find out during the GFC, the industry track record of the 2000-2003 period was not repeated, as in early 2008, hedge funds had more than ten times the assets under management than eight years before (growth of +33% p.a.). Too much money had been chasing too few talent, resulting in a multiplication of hedge fund firms happily charging the infamous 2/20 (2% management fee, 20% performance fee) model.

What many investors had to find out during the difficult days of 2008/09: during times of market illiquidity: some funds can simply „gate“ fund assets, meaning not allowing any redemptions, as forced fire sales of illiquid assets could strongly impact the remaining investors and hence were not executed. That led to some funds being shut for several quarters, with some still charging the same amounts of fees. The air of invincibility that many hedge fund managers had shown previously was proven wrong and the backlash by the investment public followed suit. It took 8 full years until the HF industry AuM reached pre-GFC levels (while US equity markets had reached the previous peak already in 2013).

Yet, despite a rather critical attitude to the industry by the investment public, the asset class still exists and has seen its assets grow at the same pace as the global stock market capitalization. Undoubtedly, the fierce competition for client assets, paired with a strong demand for professional reporting and for disclosing the purported edge in investing of each hedge fund manager has helped improve the general standards by an evolutionary process, as underperforming managers are facing outflows.

However, the whole industry is getting more differentiated, with what appears to be an ever-growing number of different hedge fund strategies. The selection process, based on a resource-intensive due diligence including detailed analysis both on a quantitative and qualitative level, is key. Depending on a given client’s needs and risk profile, a diversified hedge fund portfolio may then be constructed with the full range in terms of the risk/return profile, from a focus on defensive and stable returns to more volatile and hence typically higher returns.

Number of funds and AuM per hedge fund strategy

At St. Gotthard Fund Management, we have chosen a rather conservative approach to our hedge fund strategy, with a particular emphasis on strategies that deliver positive returns in a generally adverse environment for traditional asset classes. Thus, portfolio diversification benefits are maximized, with much more stable total portfolio returns compared to those long-only investment strategies that are almost pervasive in today’s discretionary mandates run by private banks.

Thanks to our successful cooperation with the renowned hedge fund advisory company Sussex Partners looking back to almost two decades of providing valuable analysis and insight to its clients, we can offer a high level of competence and have been able to structure our own hedge fund investment strategy and started to build a successful track record which is undergoing a significant stress test in the first months of 2022. The results to date have been confirming our expectations of providing positive returns, acting as a welcome portfolio stabilizer at times of significant stock and bond market losses.

Volatility here to stay

The signals from the inflation front to us are clear: there is a tidal change in central bank policy coming. After a quarter century of loose monetary policy throughout the industrialized world, we must brace for a more difficult period ahead, as the household sector’s well-anchored inflation expectations, once set loose, could result in a very sticky form of inflation far above the norm of the past 20 years. We have already seen the first innings in the process of economic agents adjusting to an environment unseen in more than 40 years, with for example a very high performance dispersion among equity sectors in the past months.

Monthly return dispersion among global equity sectors

Add to an already difficult set of challenges for monetary (and fiscal, for that matter) policy a grave geopolitical situation with an amount of military confrontation unseen for decades in Europe as well as of economic sanctions on an unprecedented scale, any expectation of a continued sailing in calm waters, as had been the case for most of the previous decade, appears vain to us. The economic fallout depends on many different factors, and the prospect of a war raging for months at the eastern fringes of the European Union makes the longer-term consequences of the Russian invasion attempt into Ukraine even harder to assess.

But even if a swift resolution of the military conflict or at least a cease-fire was to take place in Ukraine, something we do not consider as a main scenario unfortunately, we do not see any return to the calmer waters of the 2010s, for the following reasons:

  • The global economy is still adjusting to the repercussions of the biggest economic shock since WW2 (the covid pandemic), with many companies and households recovering from the blow dealt by the lockdowns and other restrictions imposed to impede virus infections. Even at the absence of major geopolitical turmoil, this recovery process likely is to take years rather than months.
  • Following the unprecedented fiscal stimulus that was provided by governments especially in industrialized countries in the wake of the pandemic, many countries’ government indebtedness calls for ‘tightening the belt’, which by definition would increase the amplitude of coming business cycles and thus result in higher financial market volatility.
  • The experience of the government being in full charge of so many levels of casual life during times of crisis has created a sense of dependability upon the state. At the next business cycle downturn, despite stretched government finances, calls for a “better social safety net” may well be heeded in some countries, further aggravating the governments’ financial situations.
  • The stubborn stickiness of inflation will make many households poorer on the basis of their purchasing power. Therefore, demand for compensating wage increases will explode, further complicating central banks’ aims of stabilizing price levels. The risk of a wage-price spiral is the highest in decades.
  • The business sector got used to very low levels of interest rates, thanks to the largesse of central banks on the back of contained inflation in the past 20 years. Government bond yields could rise stiffly over the coming years, and the spreads for corporate bonds, which have been on the low side lately, but started to jump on the back of the conflict in Ukraine, still have much room to rise – with the effect of many “zombie companies” potentially to cause major havoc on its suppliers and clients in case of their demise.
  • Trend growth in major economies is set to decline as a direct consequence of the decreasing working population and the high capital stock, making marginal productivity gains increasingly difficult. Lower trend growth means a higher probability of recessions to occur, further adding to the factors that will keep financial market fluctuations high.

Global high yield spreads over Treasuries

Bond market woes

Up until 2014, negatively yielding bonds were rather unthinkable, despite some experience with negative interest rates back in the 1970s in the case of Switzerland during times of strong capital imports, but back then, this measure was sold as fighting the strong appreciation of the Swiss franc after the breakdown of the Bretton Woods system.

Things started to turn after the Euro crisis that led to a wave of austerity in Europe, depressing demand and increasing concerns about impending deflation. The ECB cut interest below the “zero bound” in order to fight deflationary forces in two steps of 10 basis points each. According to Bloomberg data, the notional outstanding amount of bonds with negative yields to maturity rose to above 3 trillion USD by end-2014 from virtually zero the year before. By September 2016, more than 12 trillion of outstanding bonds guaranteed losses for their holders until maturity (in nominal terms, that is, before inflation), only to drop to below 6 trillion some two years later. In late 2020, a peak was reached at a level of above 18 trillion USD. The quite steep rise in bond yields on the back of historically high inflation rates has led to this figure to drop by 80% to below 4 trillion USD as we write.

Outstanding bonds globally with negative yield to maturity (YTM)

How will companies react if weaned off cheap rates? In an age of elevated inflation rates, typically default rates are low as the price increases for their products enable companies to grow their cash flows and service debt. After all, it is not the nominal interest rate that decides the longer-term outlook, but the real interest rate, the one after subtracting inflation and inflation expectations, respectively. Therefore, as long as real rates do not rise strongly, all is good, right? Unfortunately not, as the spike in so many different commodity prices and in particular crude oil has raised concerns that, as happened in the 1970s, an oil shock is a very real scenario, plunging the economy into recession at a time when high inflation rates are gripping the country.

Global bonds’ average yield to maturity

King dollar being dethroned?

After the fall of the Iron Curtain a good three decades ago, the US was the sole superpower, dominating global affairs and ruling the global economy. The US dollar had risen to the major trading currency in international trade, and global demand for the greenback translated into an abundant supply of global savings that sought its way into the US national currency, financing the chronic current account deficits that were the result of US consumers’ insatiable demand. However, in regular frequency, and often in connection with a significant loss in relative purchasing power, the dollar devalued relative to other currencies. The phases in which the greenback rose against a basket of currencies often led to stress in many emerging markets as many economies were dependent on a constant inflow of foreign exchange due to their own chronic current account deficits.

Trade-weighted USD Index

Supplying the global economy with its own national currency brings about advantages for the issuing country, as the mentioned funding from abroad pushes down the domestic yield level. Access to the currency was increasingly used as a political instrument, pressing non-conformist countries by excluding them from dollar transactions (so-called secondary sanctions). The case of the Russian sanctions in 2014 (for the annexation of Crimea and supporting the “rebels” in Donbas) is instructive for our point: Russia consistently reduced its holdings of USD-denominated assets, as can be seen by official Treasury data (check). The aim was immunizing the national economy from any punitive measures by the US.

Looking ahead, we take the view that the more the stick of USD sanctions is used, the less effective it will be as more and more economies will aim to reduce the dependency on the US dollar, notably the elephant in the room, China, which has amassed a cumulative current account surplus of USD 4trn over the past 20 years. This would result in lower international demand for the US dollar, and consequently higher yields as less export revenues will be recycled back into the US currency.

Back to the gold standard?

Returning to a currency system based on precious metals may appear a bit stretched to outright delirious, however the world is falling more and more into blocks, with the West’s aspirations to bring freedom (in the Western liberal-democratic sense) to the whole planet fainting by the day. With consensus on the global level all but disppeared, what will be the basis for international trade in a post-USD world? Some form of a commodity-based currency system quite plausibly is the answer. Whether it is outright, or by some form of implicit consensus, the fact that oil futures and also gold futures are trading in Shanghai against the Chinese yuan, with both settling physically, means that Russia can trade its oil for gold. The fact that China has not imposed any sanctions on Russia would speak in favor of this avenue being continued.

One future scenario among others is China increasingly isolating itself from the West, with its huge demand for commodities being increasingly met by Russian exports. Despite the ostentious friendliness between the two countries, a certain level of distrust in each other will likely persist, therefore one should not expect Russia accepting billions of Chinese fiat currency, but rather hard assets such as gold. China ranks first among all countries in terms of gold production, therefore it will not have problems paying for the oil and other commodities. Furthermore, Chinese goods will be also used to pay for them, removing the need to transact in any fiat currency, barring a Western one.

Such a scenario in our view would increase financial market instability, because the dampening effect of dollar recycling back into the US system (via buying Treasuries or other US-based assets) will be less and less taking place in the coming years.


  • After decades of great success, the 60/40 approach to investing is bound to deliver disappointing results. A more active approach to managing portfolios hence is necessary.
  • The current uncertainty with a large-scale military conflict taking place in Europe is adding to short-term volatility. There are however many reasons to expect much more of a roller coaster in the coming years as monetary largesse will be more difficult in the face of stubborn inflation.
  • We consider a good selection of hedge funds to provide great benefits on a portfolio level in the coming years. While the asset class as a whole suffered from disappointing results post-GFC, it is striking how many talented managers were able to provide superior returns over the years. A very strong selection to find the right talent is highly important.
  • Volatility will also be a continuing feature of digital assets that we see as another potential candidate for clients that can gut strong fluctuations. In the long term, we are convinced that this asset class will continue to thrive, but likely with strong bear markets in between.
  • Bond investors will increasingly have to stomach losses, we fear, as the yield levels at one point will necessarily rise in order to quell price pressures out of the system. For now, longer yields appear to be sitting on a sleeping volcano.
  • Equities 10-year prospects are bleak in historical comparison, with potentially steep losses adjusted for purchasing power threatening. We expect however very wide moves in both directions over this very long period, with the advice of having dry powder ready when the world appears to fall apart.

DISCLAIMER: This document is intended for marketing purposes.

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