Twin Bubbles And Something That’s Never Happened Before

So far, 2022 hasn’t been the best year for humanity.

Ukraine isn’t the world’s only humanitarian crisis. It’s important we don’t forget that. But the war in eastern Europe does pose a different kind of threat than, say, the catastrophe in Yemen or the conflict in Syria. Houthi drone attacks on the Saudis are so routine they barely make the news anymore, unless they threaten Aramco facilities. Occasionally, Israel will target Iranian troops inside of Syria, but again, missiles landing near Damascus never land above the fold. And there was one harrowing moment in late 2015 when Turkey shot down a Russian warplane just a few months into Vladimir Putin’s campaign to prop up the Assad regime. But the Ukraine situation has the potential to spiral into a global conflict at any moment. The loss of the Moskva was humiliating for the Kremlin and there’s talk that Putin could resort to tactical nuclear weapons.

Again, it’s been a rough year. Already. Especially for a species still recovering from a bruising two-year battle with Mother Nature who, one imagines, isn’t done with us yet. In fact, she’ll probably get even angrier with us if we start nuking each other.

What happens to markets (which, you’re reminded, are mere figments of our imagination, just like the money we make and lose trading them) is always secondary to human suffering. But having accorded the proper respect to war and disease, and having covered famine extensively over the past several weeks, I’m free to mourn the plight of investors, for whom 2022 has been quite cruel.

I’ve used the simple figure (below) a few times and I’ll surely use it again as it quantifies the scope of the “diversification desperation” engendered by the worst drawdown for bonds in modern history.

Everyone knows the story. Hopefully, you can recite it from memory. The return of macro volatility, and particularly inflation uncertainty and red-hot nominal growth, have undermined long-duration assets while prompting policymakers to threaten aggressive rate hikes to the detriment of richly-valued stocks and bonds.

That’s a double whammy of sorts — richly-valued stocks are generally long-duration equities, and the situation is compounded by the fact that some of those stocks are heavily weighted at the index level. Ultimately, both stocks and bonds were in a bubble thanks to a policy bent made possible by subdued inflation and slow growth across the developed world. When those two macro conditions ceased to hold, the twin bubbles were at risk.

“Nearly a decade into a monetary policy regime of extraordinary accommodation that included zero interest rate policy and trillions of dollars of central bank asset purchases, both asset classes became very expensive,” JonesTrading’s Mike O’Rourke wrote this week, dusting off his “Reverse Fed Model” inaugurated five years ago.

By adding 10-year yields to the S&P earnings yield, one can assess “how expensive both [stocks and bonds] are relative to history,” O’Rourke remarked, on the way to noting that until recently, headline CPI “had never exceeded the Reverse Fed Model.” The next day, March’s CPI data showed prices accelerated again, as expected. The figure (below) is updated with March’s print.

Never before have equity and bond yields trailed inflation. That’s suggestive of a bubble in both, especially in the context of elevated price pressures.

“In the case of either asset class, stocks or bonds, prices should adjust so their respective yields exceed inflation, otherwise, an investor is taking on risk for an investment that is not maintaining its purchasing power,” O’Rourke wrote, in the same note, adding that,

Over the past six decades, the Reverse Fed Model reading on average has been more than 800bps above YoY CPI inflation. As usual, different episodes have different ranges. On average over the past decade, it has been 500bps. [T]he Reverse Fed Model reading [is more than] 121bps below CPI inflation. While acknowledging inflation is likely peaking, it is not set to collapse. It took extreme circumstances to push valuations to such extreme levels. Since there has never been a recorded episode of inflation running hotter than the combined yields, it makes the case that there is still a very high level of risk in both stock and bond prices.

That’s trouble, and it underscores the notion that balanced portfolios aren’t out of the woods yet, or at least not if we continue to define “balanced” in terms of stocks and long-term bonds.

“While in the last 30 years bonds were the most reliable ‘risk off’ hedge, the buffer from bonds and equity/bond correlations becomes less reliable with low bond yields and elevated inflation,” Goldman’s Christian Mueller-Glissmann said, on the way to cautioning that “many ‘safe assets’ now face headwinds from rising rates — managing duration risk embedded in safe havens becomes more important in periods of elevated inflation.”

That speaks to the points made above, and as Goldman went on to note, “many of the ‘safe assets’ with the highest downside correlation to the S&P 500 also had a very negative correlation with the US 10-year yield.” The only exception is the dollar, but Mueller-Glissmann fretted that some of the tailwinds for the greenback (and thereby some of its capacity to hedge a portfolio) may be diminished given how much Fed tightening is already priced in.

Although Goldman said bonds will probably rally in the event the US were to head into recession, “inflation volatility drove more rates volatility and lower risk-adjusted returns for long-duration bonds” in the past. Once again: The return of macro volatility is bad news for long-duration assets.

What to do? Well, Mueller-Glissmann said that although it’s likely too early for the recession steepener (Remember: This is probably not the re-steepening you’re looking for), eventually shorter-duration bonds could “offer a better risk reduction/cost trade-off than US 10-year bonds.” Two-year yields, Goldman noted, would likely fall as recession risk becomes clear, but increase only gradually in a recovery.