Though the Federal Reserve’s efforts to keep markets running and boost the economy are just getting into gear, its asset portfolio has reached levels never seen before.
The central bank’s balance sheet, which consists largely of bonds and other assets it has purchased over the years, ballooned to $5.3 trillion for the week ending Wednesday. That’s well above the $4.52 trillion peak it hit in mid-May 2016, before the Fed started rolling off the bonds it had acquired during and after the Great Recession.
This latest peak has occurred in rapid fashion, the result of expansion begun in small steps earlier this year and then accelerated with the growth of the coronavirus crisis.
Just over the past week, the increase was 12.4%, partly a function of the Fed adding $255 billion in Treasury securities plus $19 billion in mortgage-backed securities as the Fed has entered into another round of quantitative easing. The biggest growth area proportionately, though, was in central bank currency swaps, which rose from just $25.2 billion a week ago to $206.1 billion in the latest reporting.
The Fed has greatly expanded its currency swaps with other central banks to include not only its traditional partners but also a slew of others around the world amid a huge demand for dollar-denominated assets.
On the way to $10 trillion
If things proceed as forecast, the Fed is just getting started.
“Unlimited QE & emergency liquidity programs should see the Fed balance sheet double in size over 2020,” Mark Cabana, rates strategist at Bank of America Global Research, said in a note.
The Fed had originally indicated it was going to add $700 billion to its bond portfolio — $500 billion in Treasurys and $200 billion in mortgage-backed securities. However, it switched earlier this week to an open-ended program in response to tumult in financial markets.
Wall Street now anticipates the balance sheet could hit $10 trillion this year as the Fed affirms its whatever–it-takes commitment to softening the coronavirus blow. Fed Chairman Jerome Powell told NBC’s “TODAY” show Thursday that the central bank will “aggressively and forthrightly” continue its efforts and will not “run out of ammunition.”
That means the balance sheet likely will hit $7 trillion by June, or about a $2.5 trillion gain from its previous peak, according to Citigroup. Ultimately, Wall Street forecasts are increasingly looking for a $10 trillion balance sheet that would signal a $4.5 trillion expansion, greater than the $3.7 trillion growth during and after the financial crisis.
Critics have worried about the possibility of inflation resulting from all that extra cash in the system, though it hasn’t been a problem since the asset purchases started in late 2008.
“Markets will have learned well from the 2008 experience that this increase in balance sheet size is not inflationary in any near-term sense,” Citigroup economist Andrew Hollenhorst said in a note. “In fact, the sharp drop in demand and prices for certain services and energy implies a significantly lower trajectory for both core and headline inflation.”
The balance sheet expansion creates bank reserves that the Fed credits institutions in exchange for the securities it buys. The current level of reserves at the Fed is just over $2 trillion, well above the $1.5 trillion the Fed says it was targeting as a healthy level to meet current demand.
Do fundamental managers really struggle to match that breadth?
Even the most seasoned fundamental equity analyst can only cover 30 or 40 stocks. If you do the math, if you have to cover 6,000 emerging markets stocks regularly, and let’s say that 40 stocks are the most one analyst can cover, you need 150 fundamental analysts to cover that many stocks. Does any firm have that many fundamental analysts covering emerging markets?
Is risk management part of that EMs sweet spot for quants, too?
Everyone knows that emerging markets are more volatile stocks than, say, U.S. large cap. Risk models are relevant everywhere, but become even more relevant in an area like EMs where the stocks you trade move around more than in other areas. A good quant manager builds its own proprietary risk model – we don’t just rely on standard providers. We build our own risk model that is attuned to our process and can better determine the risk in our portfolios. It’s much more finely honed in terms of how we position size a name. Once we like a name, we use our algorithm to determine how much we can buy of that name.
For example, we have simple rules such as if you’re a biotech name, we target half the weight of any single name as elsewhere because biotechs are much more volatile, and it’s an all-or-nothing story when it comes to trial phases. So, in an area like that we diversify our bets by buying more names.
Similarly, on riskier names – typically small cap names – and high beta or more volatile names, we take smaller positions than we do on Alibaba or Tencent, for example, because for various reasons there’s less liquidity in those names. So, the focus in our risk model is essentially that for every name our position-sizing algorithm determines how much we should buy. That’s critical in emerging markets, where names are riskier than in developed markets.
You don’t meet with company management as part of your strategy. Is that a strength compared to a fundamental manager?
It’s just a different approach and philosophy. Quants are disciplined, and we try to quantify everything. To us, you can tell the quality of management story by looking at financial statements – is return on equity improving? Is return on invested capital improving? We’re not interested in a judgmental, subjective lens.
The quantitative process is about ranking everything from highest to lowest in every sector, and then trying to buy the highest names and sell names that are going down in our rankings. It’s a very disciplined process that we do every day. Fundamental analysts can sometimes struggle with when to sell, because they don’t have a disciplined number telling them when to sell. Now, selling a winner is often easier – they’ve made the money, they sell it. But fundamental analysts and portfolio managers can struggle on when to sell losers – and sometimes that is because they are biased toward management. In that sense, not meeting management can make you more objective in your decision-making.
In many ways it sounds as if your strategy is optimized to seize the moment when it presents itself.
That goes back to breadth and speed. We can cover the whole globe on a daily basis, and because we look at 10 to 20 criteria per stock, such as how are you ranked on price to cash flow versus your peers, for example, we can act and trade on a daily basis. Not many active managers do that – either fundamental or quant. Our strategies are capacity constrained – we don’t want to be too greedy about assets under management – so that we are able to get in and out of names faster than other managers, and our robust infrastructure enables us to do that. That’s an advantage for us, especially in liquidity challenged areas with high transaction costs. If you can get into a name early on the upside, you can ride it up more compared to a manager getting in on a weekly rebalancing cycle or a monthly rebalancing cycle. That’s the advantage of speed we gain from daily analysis and trading.
Learn more about quantitative equity strategies focused on emerging markets and international offerings, and that use a core style of investing which employs fundamental ideas in a disciplined, risk-aware manner while seeking to generate alpha.
- 2. The Small Cap Opportunity in EM
Most investors agree that there is more inefficiency in small caps – no matter where in the world you find them – and thus more potential for alpha. In EMs, however, where small caps may be especially inefficient, there’s an opportunity that is often overlooked, and not typically part of an allocation plan by any but the largest funds.
A fairly common asset allocation plan for a U.S.-based fund would incorporate a U.S. allocation, an international allocation, and an emerging markets allocation. Historically, a reach for increased alpha in U.S. or international small caps has been more difficult because they don’t move hand-in-hand together with their large cap brethren. In both U.S. and international equities, large and small caps tend to have more independent and less correlated performance relative to large and small caps in EMs. In other words, when large caps are on an extended roll as they have been for many years now, the small caps aren’t necessarily along for the ride. In emerging markets, large caps and small caps have moved much more closely together. Further, the annualized volatility of EM large and small caps has been more similar relative to large and small caps in both U.S. and global equities.
So why does this matter? If allocations to large caps are all about beta, and allocations to small caps are about alpha, then in EMs we believe you have a better chance of getting both at the same time, rather than one or the other.
Human intelligence overlay
The emerging markets investment capacity at Mackenzie is, at a high level, constrained, so that the team can be in and out of stock ahead of managers encumbered by much larger AUM. Leveraging its computing power, the team is as nimble as they come, ranking and trading stocks daily, tapping into highly ranked names it doesn’t currently own and getting out of names that have fallen down the ranking.
Daily trading and daily rebalancing require a strong infrastructure, especially with a 24/6 clock (Middle East markets are open on Sunday). Mackenzie’s EM team spends a lot of time making sure that its models can run several times over the course of a day – as Asia opens and closes, then Europe, and finally the U.S.
“The world never stops for anyone in terms of the rebalancing cycle, so when other managers say they rebalance monthly or weekly, that’s a lot of missed opportunity, and it’s why we scrape data daily and rank stocks daily. There is always new information out there, and a name might still look cheap in a week or two, but I’d rather buy today than five days later when the stock has run up a lot already,” says Datta.
A common knock against quant strategies is that they are “black box,” meaning they lack transparency and turn over all decisions to computers. Embedded in the process at Mackenzie Investments, however, is a feature that not many other quantitative shops offer – serious and detailed human review. If there is one thing Datta makes clear he abhors it’s the “garbage in, garbage out” results of unchecked data dumping.
“It’s even more an issue in emerging markets because the data is dirtier there,” says Datta. “Most quants claim they do some statistical checks, but every trade we do is vetted or checked by either myself or my colleagues in the portfolio management and research teams at Mackenzie. And we do find names that we pull on an almost daily basis. We don’t trade them because we found that some variable the model was looking at was not correct, or that various data sources didn’t agree. Why are we selling a name? Why did we buy this for the first time? We dig deeper. If the data is bad you’re making a wrong investment decision, so we do spend time making sure the data is clean on a name-by-name basis in our buys and sells. Pulling trades is something we do almost every day, and certainly more prevalent in our emerging markets strategies than it is in our developed market strategies.”
All of this requires top-level talent, and Datta builds his team based on their programming excellence, and with an eye consistently on the future. “One trait of our quant business is that we mix the experienced people like me with the tech-savvy youth, not all of whom need to be PhDs. There are plenty of smart people with undergrad and masters’ degrees out there. The importance of mixing experience and bright, new thinking is that technology changes at a very fast pace, and it will change even faster going forward. Today, everyone uses [the programming language] Python. That was not the case five years ago, and I don’t know what the new Python will be five years from now, but I can tell you it won’t be Python. It will be something else.”
The human factor extends to EM trade execution as well, where varied exchanges, trade settlement processes, and so forth come into play.
“We have as much sophistication and discipline in our execution as we do in our stock picking and risk management – it’s all integrated into a single process,” says Datta.
The firm has proprietary market impact/trade cost models for every trade, with key drivers such as the level of liquidity demanded and stock volatility. According to Datta, its actual EM transaction costs have always come in slightly below what has been anticipated – a clear sign that trade execution is solid. “We deal with many brokers, and we are upfront in telling them that we trade a lot of names every day and we try to get the lowest commission possible because of the volume business we do,” says Datta. “And we let them know they’ll be measured versus yesterday’s closing price and VWAP [volume-weighted average price]. We monitor them closely, and if a broker is not doing well, we cut them off or lower the trading with them. It’s a very efficient process.”
Strong execution is particularly relevant when shorting an emerging markets’ stock, which is something that sophisticated investors sometimes avoid. It can be done through swaps, but execution is crucial when shorting in different regions of the world. “For example, there are plenty of hedge funds out there that appear to be shorting in Asia and China, but if you dig deep most of them have a long bias and all they’re shorting is the benchmark,” says Datta. “With the market-neutral type product such as we have in emerging markets, we actually short single stocks in almost all emerging markets.”
Wary Private Equity With $2 Trillion War Chest Sits Out Carnage
The Gulf region’s rainy day funds are bracing for the deluge.
On top of the collapse of oil prices and meltdown in global markets, Gulf sovereign wealth funds are channeling some of their billions back to counter the recession triggered by the coronavirus pandemic. The decline in assets could exceed $300 billion this year, according to the Institute of International Finance, the industry’s global association.
The impact will echo all the way to Wall Street, where asset managers count on capital from the funds sponsored by Abu Dhabi, Kuwait, Qatar and Saudi Arabia. Now that these countries need the cash back home, hedge funds and private-equity firms risk losing a substantial piece of business.
“These interlinked shocks – an oil supply shock and covid19 demand shock – are weakening oil revenues, a source of new capital for sovereign funds, and significantly increasing spending needs,” said Rachel Ziemba, founder of advisory firm Ziemba Insights. “These funds were already barely receiving new capital in the last few years, now there will likely be drawdowns.”
$2 Trillion Assets
Middle East wealth funds built up assets in excess of $2 trillion during the past few decades, building a cushion for when oil runs out or revenues drop. They have stakes in Uber Technologies Inc., Barclays Plc, and swathes of European and U.S. property.
Saudi Arabia’s Public Investment Fund has also committed giant sums to a Blackstone Group Inc.’s U.S. infrastructure fund and Softbank Group Corp.’s $100 billion Vision Fund. Other funds in the region also have significant placements with Carlyle Group Inc., BlackRock Inc. and KKR & Co. Inc.
Exactly how much the funds have placed and with whom remain undisclosed. Most don’t even report the value of assets they manage. Abu Dhabi Investment Authority is one of the few that publishes an annual report, and that only includes broad guidance on strategy and performance.
It’s not just the wealth funds in the Middle East that are suffering. Norway looks set to withdraw a record $13 billion from its giant sovereign wealth fund to help pay for stimulus measures. Russia is also likely to draw down on its reserves as it wages an oil price war with Saudi Arabia.
Still, some analysts say fears of a large withdrawal of cash from markets are overblown, and dealing with crises like this is what sovereign funds were established for.
“It is important to remember that most sovereign wealth funds are designed to act as buffers against budget deficits, and withdrawals do happen often even if they do not make the headlines,” said Diego Lopez, managing director of Global SWF, an advisory boutique specialized in Sovereign Wealth Funds and Institutional Investors. Most funds won’t make immediate changes to how they invest, Lopez said, but “investment activity may slow down in some of the asset classes and may increase in others.”
The decline in asset values of the Gulf funds is set to be deeper than the drop in 2015, the last time crude prices collapsed, according to IIF estimates. Back then, it was just an oil price shock. This time the funds face a combination of a slump in the value of their investments, coupled with a need to spend cash at home now.
Sovereign funds in Abu Dhabi, Kuwait and Qatar will account for the bulk of the declines this year, with the assets of each set to drop by around $100 billion, according to the IIF.
In contrast to 2015, Saudi Arabia will likely focus on borrowing rather than drawing down PIF reserves, according to Garbis Iradian, chief economist for the Middle East and North Africa at IIF. Five years ago, the Saudi Arabian Monetary Authority pulled as much as $70 billion from global asset managers to help plug the kingdom’s deficit that year.
Last week, Finance Minister Mohammed Al Jadaan said Saudi Arabia would fund an expected larger deficit through borrowing more rather than drawing down reserves.
The last time oil prices sank global sovereign fund and central bank assets were expected to shrink by about $1.2 trillion in 2015, according to estimates at the time by UBS Group AG. How much ends up being withdrawn this time will depend on how deep the economic slowdown created by coronavirus and the oil slump turns out to be. That will not become clear for several more months.
Either way, asset managers may not be able to rely on large allocations of Gulf petrodollars much longer. That $2 trillion of savings could be gone in 15 years if governments in the region don’t diversify their economies and trim wasteful spending, the International Monetary Fund warned in February, before the latest oil price slump.