Why was last year’s historic 60/40 drawdown so shocking to so many investors, professional, amateur and everyone in-between?

Well, anything that’s “historic” (and particularly things that are historically bad) tends to shock people, but outsized losses for stock-bond portfolios in 2022 were uniquely uncomfortable because they called into question the correlation assumption that underpinned two decades of asset allocation dogma.

Stock and bond returns were supposed to be negatively correlated. Bonds cushioned stock losses in equity bear markets. Fixed income was less volatile, so you could safely employ leverage on the bond side to get more juice. And so on.

It wasn’t so much that serious market participants didn’t understand the extent to which that treasured correlation assumption was itself predicated on assumptions about macro realities and geopolitical relations. Rather, the issue was that no one could conceive of a scenario in which those macro and geopolitical realities would be upended overnight. And then they were. Upended overnight, I mean.

The pandemic shattered supply chains, turning two generations of ordained just-in-time ministers into faithless priests. As goods stopped moving around the globe, a nascent re-shoring push originally catalyzed by a wave of populist sentiment in Western democracies became an economic necessity. All pretensions to austerity were abandoned in favor of fiscal-monetary partnerships aimed at preventing economic depressions and outright deflation in the developed world. But, in a tragic irony that appears entirely predictable with hindsight, the collision of stimulus with constrained supply sowed the seeds of inflation. At the same time, the realization among electorates that money does, in fact, “grow on trees” was fuel on a bonfire of social unrest. Suddenly, Main Street was aware of various societal injustices and also of the link between different manifestations of inequality. Voters were also aware of lawmakers’ capacity to paper over problems with freshly-created money. Federal deficits didn’t matter after all. Labor began to plot a comeback as an economic actor with clout. Then war came to Europe, sanctions came to Russia, Russia went to China and economists were left to ponder the prospect of regionalized trade, bloc-based finance and other developments which all pointed to de-globalization.

It was (every last bit of it) inflationary, and it served notice that what we came to regard as “normal” following the collapse of the Soviet Union, was in fact just an anomalous period of relative calm both in international affairs and economics (I emphasize “relative” to account for the fact that this “calm,” “peaceful” period also saw its share of war and crisis).

And, so, our world was shattered like so many supply chains. Everything we regarded as settled was suddenly up for debate, from the most existential issues (Have we, or have we not, overcome our inclination to large-scale violence and war?) to relatively trivial concerns (Can we, or can we not, manage inflation around a target, and if we can’t, then how can we be sure that bonds won’t be a source of portfolio risk as opposed to a vol-suppressant?). The 60/40 drawdown was a microcosm of a much larger reckoning.

Given the momentous nature of last year’s macro and geopolitical shifts, it’s understandable that the investor community is in a state of shock. Now, consensus has seemingly coalesced around the idea that we aren’t going back to anything that even looks like a low-inflation world characterized by long periods of macro and geopolitical stability, and that as such, 60/40 is dead and real assets are the only viable hedge.

If our misplaced faith in the 60/40 world was the product of recency bias, I suppose the fatalistic notion that 60/40 is dead and buried forever can be called “recent recency bias.” Over the past several weeks, it too began to wrong-foot some investor cohorts as the stock-bond correlation flipped back.

“We have now seen the trailing bond / stock correlation sharp[ly] revers[e], while [the] equities realized [vol] compression accelerated and the ‘inflation left-tail’ risk has moderated [as] we pushed closer to the perceived end of tightening cycle,” Nomura’s Charlie McElligott said Tuesday.

Why does that matter? As McElligott explained, “active folks” are currently being caught “off guard and underestimating the flow dynamics from systematic investors [due] to their recency bias to the ‘legacy’ world we were living in during the ‘inflation overshoot = FCI tightening’ phase of the journey late last year.”

The scare quotes he used around “legacy” were presumably there to denote that “legacy” is a misnomer of sorts when we’re referring to the past 12 months — as I put it above, it’s “recent recency bias.”

That regime (elevated inflation forcing the Fed to constantly lean against any FCI easing with rate hikes and hawkish rhetoric) compelled active managers to keep their equity allocations “at extremely low levels,” McElligott went on.

Now, some in the active universe might be behind the curve, and are perhaps unaware of what’s going on from a mechanical flows perspective. The vol control / target vol universe uses portfolio vol which, as Charlie reminded investors, captures both stocks and bonds. As discussed here+ Monday, realized equity vol has collapsed, and rates vol is calming down too. When considered with the correlation flip noted above, you have a recipe for re-leveraging.

“Not only is the equities realized vol dynamic cratering to 0%ile-type ranks, you now too have this nascent softening rate vol compression plus a bond / stock correlation flip further contributing to the deployment of additional leverage and ‘buying power’ to reach target equities / vol allocations,” McElligott said, adding that “these dynamics are part of the same feedback loop” which has seen CTA net exposure to global equities rise nearly $43 billion over the past month.

Of course, it’s all about understanding and anticipating the ebb and flow. Although Charlie said it’s possible that ongoing mechanical demand for equities alongside “pervasive” under-positioning as earnings roll in, could catalyze a melt-up over the next week or two, “‘extreme’ mechanical buying… fed by vol compression [could] set up the next de-risking flow looking closer to a few weeks further out.”