Key points

• Charlie is about to switch careers to running his own fund and will continue looking and investing forward 18 months.
• One of his core strategic beliefs is that cross-asset class volatility is going to increase over the next 18 months.
• He is adding Australian banks to his portfolio at 600-basis-point yield premiums to cash.

The chart below is amazing and has clear ramifications for investment markets and investment strategy.

Yes, we have reached the point where planet earth almost has full penetration of mobile phones.

The brave new world

When I first started in stockbroking 22 years ago there was a clear institutional information advantage in terms of time, and in turn, price.  Back then, we even coined the term “Herald readers’ effect” to describe the secondary price and volume response to news/data/earnings etc. from the day before.

Nowadays, due to advances in telecommunications there is a completely level playing field in terms of economic and financial information. The man in the street knows the US non-farm payrolls number on his iPhone at exactly the same time as a hedge fund trader in New York.

Then you overlay that around 60% of all currency, bond, commodity and equity market daily turnover is high frequency trading (HFT), and you can see why I come to the conclusion that markets are extremely efficient at “pricing the present” yet horribly inefficient at “pricing the future”.

The sweet-spot seems to be about 18 months into the future. If you can successfully forecast the headlines of the day 18 months from today, then set a portfolio to benefit from those headlines, you should be able to benefit from what I call the “time arbitrage” in markets. Time and conviction are your friends in markets that purely discount the present.

In these articles I have tried very hard NOT to commentate on the present. I have tried to always look forward and make forecasts: some have proved better than others! That will continue to be my approach as I switch careers to running my own fund – always looking and investing forward 18 months: I believe it’s the ONLY way to generate outperformance in what have become incredibly short-termist markets.

One of my core strategic beliefs is that cross-asset class volatility is going to increase over the next 18 months. In fact, it has clearly already started to increase in the bond, currency, equity and commodity markets. I would be unwise to believe this is just a short-term event.

The butterfly effect

A few years ago I remember reading an interesting story depicting the start of the US subprime crisis, which the author could apparently trace back to just one mortgage default in an American backwater. Obviously, the story is a financial metaphor for the butterfly, which after flapping its wings, spreads ever increasing vibrations across the world before ultimately they become a tornado and unleash devastating destruction in an un-related destination.

This isn’t a warning that financial Armageddon is imminent, but a cautionary reminder for investors that we live in a very inter-related world, where asset classes remain inextricably linked by high speed cross border liquidity flows which in turn are effected by central bank policy. Just as central bank monetary policy has acted to lower interest rates and compress volatility, it’s clear that any change in policy settings can have the reverse effect. The recent spike in EU bond yields has created financial ripples in the form of heightened volatility across global financial markets and asset classes. I have written on cross asset volatility before but I think investors need to be aware that financial markets are entering a more volatile period.

A new regime

The other important contribution to bond market volatility is the new financial regulatory environment.  In an effort to make banks safer, capital regulations have required banks to downsize both trading operations and inventory holdings. Unfortunately, the unintended consequence is lower liquidity in the market place. Once again, a government-led initiative has increased the illiquidity of bonds.

At the same time, banks have been required to hold less risky bonds as collateral, which has further reduced bank inventory and increased illiquidity. Unsurprisingly, computer driven models have also exacerbated the move in bond yields as huge investment flows move down a one-way street at lightning speed. There is no doubt in my mind that a combination of more stringent bank regulations and high frequency trading models have the potential to create more flash crashes. Beware, more volatility ahead.

Similarly, the rise in global yields has translated to cross asset volatility in equities and a major correction for yield based equities. The realignment of risk in global bond yields has translated to heightened volatility and a savage 15-20% correction in Australian banks. With volatility however, comes opportunity. And the bank sell-off has driven fully franked bank yields towards 6% for the majors. The benchmark valuation for SMSF trustees and retirees, is not bond yields, but the cash rate. At a 2% cash rate, the 600 basis point plus risk premium for grossed up fully franked bank yield with another rate cut on the way, looks very attractive for retirees in a super drawdown phase.

The Asian equation

Meanwhile, volatility has exploded across Asian equity markets, which remain tied to US monetary policy due to fixed currency pegs. Indonesia and Thailand, which run large current account deficits funded by low interest rates denominated in US dollars, have been savaged. Even Singapore government bonds have experienced a huge sell off. Similarly, last week Chinese equity markets saw huge volatility with a 6% intra-day fall in the Shanghai Composite suddenly reversing to end up slightly on the day. Chinese equities then marched to new highs yesterday. Of course, the possibility of a Grexit remains the never-ending horror story or nightmare for financial markets. Currently, the Euro is caught in the uncertain cross currents of a possible Grexit (lower Euro) versus spiking EU bond yields (higher Euro) which only adds to the volatility of financial markets.

In a recent press conference the ECB president commented, “At very low levels of interest rates, asset prices tend to show higher volatility.” Dead right there, Mario. Particularly when central bank policy has artificially compressed asset class volatility and returns, which in turn has supported a misallocation of resources into more risky asset classes. Volatility should definitely be higher in a world of low yields and heightened risk aversion. In an effort to quell market fears, the ECB confirmed its intention to complete its QE program. However, investors remain unconvinced, and it appears profit taking has given way to outright short selling of government bonds. An ensuing battle has developed between bond bears and central banks. Stand by for more volatility.

There is no way of knowing whether the spike in bond yields will ultimately represent the initial flap of the butterfly’s wings and the start of a long term bond bear market. It’s certainly possible, but I believe after the initial spike, the rise in bond yields will be a gradual and orderly process. What I do know, is recent events represent a wake-up call for complacent investors which have become seduced by low volatility, driven by central bank policy. Volatility is back with a vengeance. But remember, volatility equals opportunity for risk aware investors.

In my model portfolios I remain zero weight long government bonds, but am adding to Australian banks at 600 basis point yield premiums to cash. Mobile phone penetration levels are good for telco data usage and I’d also be adding to Telstra at current prices on a nearly 5.40% fully franked FY16 dividend yield.

I’ll finish today with a simple overlay of the Federal Reserve’s total assets (green line) and the CBOE VIX Index. I believe the Fed’s total asset base has peaked and it is therefore fair to assume that the VIX has also bottomed. I like the idea of being long the VIX in some way in portfolios as a way of playing a rise in volatility from here as the Fed starts the cash rate normalisation process in September.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.