Listen, if you’re one of the countless investors who have benefited from the “have your cake and eat it too” dynamic that’s prevailed (almost) interrupted for going on two decades in balanced stock/bond portfolios, I don’t want to hear any complaining.
Sure, you’re to be commended for coming to the common sense conclusion that it makes sense to own both stocks and bonds because of the assumed diversification benefits, but then again, is that really a feather in your cap? I mean, can one really be “commended” for exercising common sense?
I don’t know, but what I do know is that for quite a while now, investors in balanced portfolios have enjoyed both the negative correlation between stock and bond returns/positive equity-rates correlation (that’s your diversification) while simultaneously benefiting from concurrent rallies in both assets. That, right there, is too good to be true and it’s largely down to post-crisis dynamics. Here’s Goldman, from a note out in early October when 10Y yields in the U.S. pushed to new post-2011 highs:
Lower inflation uncertainty has helped reduce global term premia structurally since the 90s – inflation volatility is close to all-time lows of the 60s and 90s. This is due to central bank inflation targeting but also structural factors that helped anchor global inflation, such as demographics, EM competition and technology. And Philips curves globally have flattened, which has reduced the late cycle pick-up in labour cost inflation. Finally, as a result of the shale revolution there is also less risk of a late cycle inflation boost from oil. And recently global QE further anchored global term premia and monetary tightening globally and also in the US has been very gradual so far.
That, as trillions in central bank liquidity injections drove investors into riskier credits and, ultimately, into stocks, catalyzing a massive rally in risk assets while the bond bull market continued apace.
Here’s a scatterplot that illustrates how correlations have been negative for nearly two decades:
Again, that negative correlation means you benefit from the diversification, but in the post-crisis years, you’ve also benefited from a simultaneous rally in both assets. In the same cited note, Goldman reminds you that the length of the current bull market in balanced equity/bond portfolios is the longest on record.
When it comes to the “having your cake and eating it too” dynamic, here’s a succinct description of things from Deutsche’s Aleksandar Kocic, for those who might have missed it:
Equity-rates correlations tend to be generally positive. Either we have a recession where bonds do well and stocks underperform or a recovery with rally in stocks and sell off in bonds. Regardless of which mode the market is in, we know what to do — we exploit the correlations.
Well, in the post 2008 recession, this was not enough. Both stocks and bonds did well. And nobody complained, because everyone was happy. While it lasted. The problem is clearly the reversal of that mode that takes us from rally in both stocks and bonds to sell off in both assets. This is the most feared scenario. And, to make things interesting, we are not very far from this regime.
Early last month, the equity-rates correlation flipped, as the early October selloff in Treasurys ran so far, so fast (during the first week of October), that stocks weren’t able to digest it, despite the fact that some of the rout was attributable to ebullient economic data.
Subsequently, bonds refused to rally to the extent some folks might have expected given the depth of the equity selloff. And so, what unfolded was an extremely rough patch for balanced portfolios as the diversification benefit disappeared while both assets sold off simultaneously.
“Due to the lack of bond reaction to equity in October (similar to February) it was one of the worst months for both standard 60/40 portfolios and risk parity portfolios since the GFC”, Goldman writes, in a new note, adding that “this highlights again the current elevated risk in multi-asset portfolios – the risk of large drawdowns in balanced equity/bond portfolios remains elevated as equity/bond correlations have been less negative, which is both due to the late cycle position and central banks’ desire to normalize policy but also a lack of available buffer due to low bond yields, especially outside the US.”
Those latter points from Goldman are important. Central banks are now predisposed to normalization if only to free up some counter-cyclical breathing room in the interest of replenishing the proverbial “ammo” ahead of the next drawdown. Between that, and the fact that rates are already so low, bonds are going to have a much harder time diversifying any equity drawdown that comes calling.
“Central banks are particularly keen to normalize monetary policy from ultra-easy levels to build up a buffer for the next recession [and] as a result, monetary policy tightening might continue despite weaker growth”, Goldman wrote a month ago, before going on to warn that “gradually rising inflation could move the central bank put further ‘out of the money’, requiring a larger ‘growth shock’ for central banks to ease policy due to limited options.”
Finally, as we saw in both February and October, bonds can in fact be the cause of the problem (i.e., stocks selloff because bond yields are rising too far, too fast), which complicates the diversification aspect further. When you get a sharp move higher in yields that catalyzes an equity rout, anyone demanding diversification from a balanced portfolio is effectively asking bonds to forget why they just sold off so that they can rally to cushion the blow from a slide in equities.
Think on that.