Who’s afraid of a multi-asset drawdown catalyzed by a bond tantrum in 2018?
Nobody, right? Because drawdowns no longer happen. The entire world has turned into China. Selling is de facto illegal.
And hell, given how much Trump seems to look up to Xi (an ironic turn given all the anti-China rhetoric that was tossed about with reckless abandon on the campaign trail), who’s to say he doesn’t take a page out of the Politburo playbook and simply put half the market on indefinite trading halt in the event his precious equity rally is imperiled?
I’m just kidding. But the bit about the multi-asset drawdown and the possibility that a bond tantrum could disrupt balanced portfolios in 2018 is an important point. Remember, we’re in the midst of the longest bull run for a balanced 60/40 portfolio in a century:
And stock-bond return correlations have been negative for the longest stretch in 100 years:
So you’re getting the best of both worlds – a simultaneous rally in stocks and bonds and the diversification that comes with a negative return correlation.
The problem with that (well besides the fact that all good things invariably come to an end even as the gambler’s fallacy has a tendency to fuck anyone who tries to predict the exact moment when things will turn) is that now, everything is stretched. Stocks, credit, and bonds. So it isn’t clear whether it makes sense to talk about “diversification” anymore. Here’s how we put it in November:
What does it mean to be “diversified” when everything is expensive?
That’s a good question. Does “diversification” help when everything is in a bubble? Maybe at the margin, right? I mean, “diversification” entails holding assets the returns on which are negatively correlated but when all of those assets are in bubble territory, the implication is that at best, returns going forward are going to constrained and at worst, returns will be negative. So while being diversified across a bunch of assets that are all expensive might help mitigate exposure to one of those assets plunging, the concept of “diversification” becomes more ambiguous in an environment where everything is overvalued.
And indeed, bonds have now become a source of risk. Any uptick in inflation that triggers a policy shock (i.e. aggressively hawkish communication from central banks) could well trigger a tantrum episode and there are very real questions as to whether the stock-bond return correlation would remain negative if the bond selloff proved to be particularly acute (i.e. it’s not clear whether equities would provide any diversification). On the flip side, with bond yields as low as they are, it’s not entirely clear that bonds will provide as much of a buffer during an equity drawdown.
“Low equity/bond correlation alongside record low cross-asset volatility is driving the volatility of an equity/bond risk parity portfolio to its lowest levels since the mid-1960s,” BofAML recently wrote, adding that while “a continued rise in equities alongside a rise in yields on the back of economic growth and perhaps inflation could help sustain multi-asset portfolio performance in 2018 and onwards, a disorderly rise in yields that comes alongside an equity market pull-back (a la 2013 bond tantrum) could be a surprise for many investors who have become conditioned to the recent environment in which bonds and equities diversify one another.”
So one question you might ask headed into 2018 is how to hedge that. Well, BofAML has one idea.
“HYG sensitivity to both rates and credit makes it an ideal candidate to hedge a simultaneous sell-off in the two asset classes,” the bank continues, in the same noted cited above. “Indeed, in such sell-offs the correlation between the two assets breaks from its typical negative range causing a sharp expansion of HYG’s beta to its risk factors”:
And see here’s the other thing about HYG puts. It seems highly likely that a rollback of central bank asset purchases in 2018 is going to allow idiosyncratic risk to manifest itself in wider spreads again. For years, central bank asset purchases have created an indiscriminate bid for credit as investors chased down the quality ladder in search of yield. Once that QE flow begins to dry up, it is entirely possible that weaker sectors within HY start to widen out and if that idiosyncratic risk from secularly challenged sectors gets acute enough, it could morph from a driver or dispersion into a directional driver of risk appetite.