It’s broken.
After a decade (or more, depending on what manifestation of the same general theme you prefer to cite) of market participants large and small crowding into somer version of a “duration infatuation” trade predicated on the deeply entrenched “slow-flation” macro zeitgeist, it’s all unwinding in 2022.
A simple 60/40 portfolio is down double-digits so far, putting this year on track to be the worst annual stretch since the financial crisis for a strategy that came to be viewed as the bedrock of prudent asset management.
This was always the risk. The idea that a balanced portfolio (wherein IG bonds hedged the equity risk) was akin to a foolproof strategy rested on the assumption that the stock-bond correlation would be negative most of the time. And it was for nearly two decades. But nothing lasts forever.
As bond yields moved ever lower in the latter stages of a four-decade bull market, the risk of so-called “tantrums” grew, alongside central banks’ efforts to effectively monopolize the market.
Time and again over the past 12 months, I mused about the ramifications for multi-asset portfolios in an environment of rising inflation. Returns seemed destined to be lower, at best. If inflation persisted, IG fixed income would suffer, as would long-duration equities which dominate US benchmarks. After a 40-year bull market, government bonds were surely a bubble, and various distortions brought about by trillions in central bank intervention raised the odds of disorderly price action. The read-through: Not only could bonds become a source of risk, they might also increase portfolio volatility. As Macro Risk Advisors’ Dean Curnutt put it, “the risk-free asset is itself the sponsor of the event, forcing equity markets to reconsider assumptions used to discount cash flows and sometimes creating a VaR shock.”
None of the above is new, but I wanted to reiterate the point(s) for two reasons. First, the tail risk is now realizing. “This has become a ‘nowhere to hide’ market,” Nomura’s Charlie McElligott said Tuesday, in the course of summing up everything said above as follows:
The legacy multi-decade “bonds / duration proxies as your hedge” construct no longer works (“balanced” or 60 / 40 funds pairing USTs and credit with equities, risk parity, “spooz and blues,” mega-cap “secular growth” as the largest Eq Index weightings, profitless unicorns everywhere — with the recent trend of pairing public equities with private books), into the inflation overshoot which has forced global CB’s to capitulate into a tightening cycle, wrecking anything with “high valuations” or “highly speculative”…which was basically everything except 1) value equities and 2) commodities circa mid-2020, both “left for dead” in the era of low rates, loose FCI and inflation cynicism.
Again: It’s broken. And not because balanced portfolios are a bad idea, but rather because “balanced” came to mean something very specific — namely, growth stocks paired with bonds.
That worked as long as a familiar list of structural forces kept inflation in check and nominal growth remained similarly subdued. But when the macro regime shifted, it stopped working. Even if growth decelerates, the persistence of inflation will compel the Fed to tighten policy, likely offsetting any re-rating in equities that might otherwise accompany falling long-end yields in response to slower growth.
The second reason I wanted to highlight the burgeoning breakdown in balanced portfolios is that it’s being exacerbated by dynamics that are familiar to regular readers. It’s not just stocks that are being whipsawed by accelerant flows.
“Look at the deeply negative / short dealer gamma location across themes / assets, as downside is sought incessantly while spot grinds pervasively lower, from mega cap equities (SPX / SPY), secular growth / duration equities (QQQ), small-cap equities (IWM), USTs (TLT) to HY credit (HYG),” McElligott went on to say, referencing the updated figures (above).
That makes everything untradable. Dealers are currently liquidity takers, not providers, Charlie emphasized. They’re selling weakness and buying strength, and not just in stocks, but in bonds and credit too. That’s one (but not the only) reason for the carnivalesque character of the daily price action.
The death blow for anyone seeking diversification or shelter from the storm: The pullback in commodities. “One of the few hiding places” has been “hit out, as the ‘gross-down’ takes more scalps and folks go heavier into cash,” McElligott said, adding that raw materials could “accelerat[e] lower off the back of profit-taking as well as stop-losses from late longs, due to increased margin requirements,” demand destruction concerns, the prospect of Iranian barrels coming back to market and, of course, new lockdowns in China, where the Party’s quixotic COVID-zero strategy is on its last stand.
“The death blow for anyone seeking diversification or shelter from the storm: The pullback in commodities.”
What’s next? The pullback in cash?
IIRC, cash was deemed the worst asset class at the start of the year. Now, probably not so much. -8% real return might look pretty good by the end of the year, as nothing has broken. Yet.
This has been my fear for awile. I ran my client portfolios through my risk system, and when you model a moderate increase in rates combined with a moderate stock selloff (10-20%) you get risk numbers going up 25% at precisely the wrong time (in a down market). Historically UST bond prices are inversely correlated with stocks most of the time- but not always. As your article spells out, this is happening now. Rates are a causal factor in the stock selloff – that usually means inflation. A modest inflation can be good for stocks- especially value, but when you start accelerating beyond 4-6% that has historically gotten stock markets into trouble (central bank reaction function of tighening). The last two days I have watched as US bonds, stocks and the US$ have been weakening or gaining together. This is more typical of EM markets and are troubling to say the least. If the situation in Ukraine improves and war winds down, we could see a nice bounce. But this shock has made a recession far more likely next year, even if it is eventually settled.
Interested in hearing more about the risk modeling, if you’re willing to share.
I don’t see, and haven’t seen, many places to hide. Lots of cash & equivs, trying to avoid the worst places, and nibbling on the most washed-out names is about it. Even then, the feels are not good. Over the past several months, I’ve had higher cash, lower vol, lower beta, lower rate sensitivity, least index-like positioning, etc in portfolios than I’ve ever had in my career – and still the happy days are few.
A bear market is like slowly tumbling down a flight of stairs, each shove sending the market down a few more treads. The market is still clawing to banisters and trying to catch itself. The market needs to give up and finish the Humpty Dumpty.
Everything is broken, I think that’s a Bob Dylan song
The recession stagflation predictions may be premature, but the future looks problematic. There’s many nested layers inside a matryosgka doll, but I feel a post pandemic mindset will play a role in future efficiency and productivity.
One nested layer that seems broken in a weird way, is the crackdown on crypto in China last Fall and then the fairly recent Russian focus:
” January 20, as Bitcoin hovered around $43,000, Russia’s equivalent of the U.S. Fed issued a “Consultation Paper” advocating that the government ban all cryptocurrency production, trading, and investing by its citizens and banks within its borders.”
That strikes me as a weird coincidence preceeding the Ukraine invasion, especially if one ponders in retrospect that Russia and China would have anticipated economic sanctions for this pending invasion.
It may not be coordinated or conspiratorial but it’s an odd puzzle piece that seems out of place. Then again, the American government is also concerned by crypto with IRS being a little more active, so maybe it’s just crypto fallout apart, versus anything related to global currency stuff?
Maybe Crypto is too hard for the Russian and Chinese Governments to control…and they sure like to control everything.
Crypto can be used to exchange Rubles or Yuans for Dollars. Both nations have reasons to have capital outflow controls.
H-Man, so when there is a bad storm, you take the boat to a safe harbor and ride it out. The last thing you do is sail into the storm.
Agreed- however, the problem is when you listen to the weatherman…..it seems like every storm heading towards me will be catastrophic.