‘Dead’ Bonds Could Be Screaming Buy As Downturn Looms

When it comes to portfolio diversifiers, Bridgewater isn’t sure whether bonds are “dead or in a coma.”

That’s according to blunt remarks from chief investment strategist Rebecca Patterson, who spoke to Bloomberg’s David Westin for this week’s episode of “Wall Street Week,” a riveting financial drama centered on the exploits of a retired economist named Larry.

Patterson was referring to so-called “diversification desperation” in an environment where reliable correlations at the heart of multi-asset portfolios (and strategies like those employed by Bridgewater) are no longer dependable.

The first quarter of 2022 was among the worst ever for bonds. Stocks managed to rally into quarter-end, but 60/40 portfolios had an extremely tough time (figure above).

I should note that Bridgewater did quite well in Q1, where that means Ray Dalio’s behemoth returned almost 17% for investors. Pure Alpha II gained 9% in March alone. As an amusing (if wholly irrelevant) aside, Elon Musk’s personal net worth now exceeds Bridgewater’s entire AUM — by $110 billion.

Patterson’s point was to underscore the utility of including commodities in portfolios as a diversifier. Certainly that looks prescient in hindsight (see what I did there?). Commodities are on track to be the best performing asset class for a second consecutive year (figure below).

I’m sure Bridgewater was positioned for the raw materials surge, and I’m certainly sympathetic to the notion that the diversification benefits of bonds are diminished, not just because inflation is rampant, but because central banks, in their efforts to corner markets, have created the conditions for “tantrums.” Of course, the Fed will always step in to ensure orderly functioning in Treasurys, but liquidity is impaired and the March FOMC minutes made mention of the need to carefully monitor conditions as balance sheet runoff gets going.

In any case, the point is just that folks are skeptical of bonds, but as PGIM co-CIO Gregory Peters told Bloomberg during the same segment, bonds are actually getting more attractive.

US growth was destined to slow on its own given an exhausted consumer, and the Fed is keen to accelerate the slowdown with aggressive tightening ironically aimed at reining in the same inflation that’s weighing on consumer psychology. The Fed will save the US consumer from inflation, but unfortunately that might mean bankrupting Main Street first via an engineered recession. (“Nice labor market you got there. Shame if something happens to it.”)

Stocks (to say nothing of STIRs) are already trading a contraction, and at least two simple ratios suggest bonds might be a screaming buy coming off the worst drawdown in history. The figure (below) shows banks versus utilities against 10-year yields.

“With Banks positively correlated to back-end rates, this is another example of the internals of the market saying we’re close to a top,” Morgan Stanley’s Mike Wilson said, adding that curve inversion “is also supportive of this relative value trade as it signals late cycle, a time when Utilities dominate early cycle groups like Banks.”

If you’re after a more stark juxtaposition, the figure (below) might work.

There again, one might be tempted to suggest bonds are either poised to rally or, at the least, could be an effective hedge against the economic deceleration stocks are clearly telegraphing.

In the same note cited above, Morgan’s Wilson wrote that “we think 30-year Treasurys offer an excellent hedge against the growth scare we expect now that the Fed is fully priced.”

“Suffice it to say we are recommending Defensives over both cyclicals and growth,” he added.