60:40, Food:Fuel

It’s been a tough year for multi-asset investors, where “tough” means all assets have incurred losses with just two exceptions: Commodities and cash.

Cash returns are deeply negative in real terms, of course, even as T-bills have outperformed virtually every asset on the planet, a rarity going back more than a century.

The simple figure (below) gives you some context for 2022. It’s not as bad as 2008 on some scores, but it’s considerably worse on others.

This state of affairs is quite vexing for a generation of investors virtually none of whom were deeply engaged in markets in a professional capacity during America’s last serious bout of inflation, and many of whom came to regard the negative stock-bond return correlation at the heart of balanced portfolios as akin to a natural law.

For years, naysayers warned that bonds’ appeal as a portfolio hedge was diminishing with each new leg of a bull market that spanned almost four decades. The lower yields went, the less scope for bonds to cushion equity drawdowns, and the more aggressive central banks were in cornering the market for bonds issued by their respective sovereigns, the more fragile those markets would become. Or so said critics.

But, as Morgan Stanley’s Andrew Sheets wrote in a note dated July 24, the dire predictions implicit in such warnings virtually never manifested in sustained, large drawdowns for balanced portfolios. “Over the years, we (and many others) have talked about how our estimates suggested historically low returns for a 60:40 portfolio and frequently, it just didn’t matter,” he said. “Global stocks and bonds continued to hum away nicely, delivering unusually strong returns and diversification.”

In 2022, the music stopped. And with it, the humming. An epochal macro regime shift changed the game. 60:40 portfolios delivered among their worst quarterly performances in recorded history during the first three months of the year. Relatedly, risk parity strategies witnessed one of the largest drawdowns in 40 years.

The index shown in the simple figure (above) uses a more “conservative” 50:50 weighting. The scare quotes are there to denote that at the lows, the diversification benefit was comparatively minuscule versus what you’d have enjoyed during Q4 2018 and March of 2020 if you held 100% stocks.

For Morgan’s Sheets, the case for diversification isn’t over. The title of his missive: “60:40 Isn’t Dead, Just Resting.” (That’s supposed to be a joke but… well, the parrot wasn’t “just resting.”)

Sheets walked through what he called “some relatively simple math.” The correlation between stocks and bonds isn’t 1. “There are still plenty of days where they don’t move together,” he wrote, which “matters” because it suggests the volatility-dampening effect hasn’t disappeared, just diminished. He proceeded to note that trailing one-year volatility for the US Aggregate Bond Index is just 6%, far calmer than equities. “Having 40% of a portfolio in anything with one-third the volatility of the other 60% will absolutely dampen overall fluctuations,” he said.

The problem, I’d venture, is that bonds could deliver bursts of volatility at annoyingly regular intervals for the foreseeable future. Sure, it’s possible (likely, even) that inflation will eventually recede and central banks in developed economies can return to forward guidance, but the RBA’s failed experiment with yield-curve control and the ongoing standoff between the Bank of Japan and an increasingly aggressive band of vigilantes, underscore the risk of assuming a return to business as usual. The market will test the ECB’s new anti-fragmentation tool, and it’ll be at least a year before anyone can draw conclusions about the interplay between rampant inflation and Fed balance sheet runoff in the US (in the context of rates vol, there’s a sense in which we should hope for a recession to short circuit the risk of a disorderly bear steepener).

“The last six months have seen the worst drawdown in bond prices in 40 years, and unusually high levels of implied volatility,” Sheets wrote, adding that “bonds have been riskier than at any point in most investors’ careers.” Implicit is the assumption that such an anomalous conjuncture can’t possibly persist. Maybe that’s right. Maybe it’s not. One thing is (almost) certain: Rates vol will remain elevated until the disconnect between sky-high inflation and DM policy rates (which, even in the most hawkish locales, are barely restrictive), is resolved.

In the same July 24 note, Sheets ventured (accidentally, I think) into existential territory. A bigger concern than the size of the 60:40 drawdown “is the relevance of diversification,” he wrote, noting that at the depths in 2002 and 2008, 60:40 portfolios suffered more extreme losses than they have during the current drawdown. What’s odd, he went on to say, is the “uniformity” of losses this year. “Almost every asset class barring commodities lost money,” Sheets remarked, before driving home the point: “Whereas those previous large drawdowns left investors wishing they had held more fixed income, this year has left investors wishing they didn’t own anything.”

As I’m always fond of reminding readers, the closer we get to living out Cormac McCarthy’s The Road, the less sense it’ll make to own anything other than food and fuel. That brings us full circle. The only two assets that worked during the first half of 2022 were food and fuel.