Hey! Guess what? We ran into some trouble on Monday.
I mean actually, we ran into some trouble last week and the proximate cause, initially anyway, was jitters about the ongoing bond rout.
As we detailed in “Judgment Day” (that was the title for our daily wrap last Tuesday, the day during which it became readily apparent to anyone with working eyes that something was about to go horribly wrong), the rapidity of the rate rise was starting to imperil the equity rally. The stock-bond return correlation was about the flip positive. There wouldn’t be anywhere to hide (not even Bitcoin, which was collapsing too).
Well sure enough, balanced portfolios ran into some “bigly” trouble as the equity selloff accelerated and bonds continued to underperform. The read-through for risk parity was obviously not good and as Goldman writes in an expansive note out Wednesday morning, “only five times since 1990 have simple risk parity and 60/40 balanced portfolios had weeks where they simultaneously sold off as much as they did last week – the last two times being during the global financial crisis.”
The issue – as we’ve been over countless times – is the rapidity of the rate rise. There is a limit to the equity market’s patience when it comes to higher bond yields (and higher breakevens). Previously, the bond market adjustment was viewed as a good thing to the extent it signaled something about the relative robustness of the economic recovery. But the rapidity of the rise in yields matters. Too far, too fast is not good and past a certain point, equities’ interpretation of that yield rise will change. Here’s Goldman from the same note mentioned above:
As we have written before, the equity/bond correlation depends on the level, speed and source of bond yield moves. The recent rapid repricing of bond yields has been again difficult for equity to digest. Since the crisis, if US 10-year yields increase by more than 2 standard deviations in a 3 month period, equities have sold off alongside bonds. When rates rise too quickly, they can weigh on growth expectations and valuations for risky assets and rate vol can spill over to equity vol.
When you couple this with a situation where everything was stretched in the first place (and coming in, stocks, bonds, and credit hadn’t been so simultaneously expensive in 100 years), diversification becomes next to impossible. As you can see from the bottom line in the following table, literally nothing has worked:
We’ll close this short piece with a classic quote from a previous post:
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.