Again and again since the pandemic, I find myself returning to the idea that what most of us mistook for a new macro-market “normal” in the three decades leading up to the public health crisis was in fact an aberration born of, and embedded within, a larger departure from the historical norm.
Simply put: The so-called “Great Moderation” was an interregnum, not an epoch, just like the disappearance of great power conflict and the onset of a secular bear market in autocracies was an interlude not “the end of history,” as Francis Fukuyama (in)famously proclaimed.
This century’s “Roarin’ 20s” marked a reversion to the historical mean, which looks a lot more like a Hobbesian state of nature than it does anyone’s idea of a collaborative utopia built on universally-accepted liberal democratic principles.
This reversion compelled asset allocators and portfolio managers to stay more engaged than they’d become accustomed to. Suddenly, the bedrock correlation assumption at the center of everything from the simplest of balanced index funds to levered target-vol strats seemed to no longer hold.
The subdued macro volatility which characterized the Great Moderation was enabled by structural disinflation. That (disinflation) gave central banks air cover to keep monetary policy loose in perpetuity and to institute, post-GFC, what former Deutsche Bank rates vol analyst Aleksandar Kocic once described as a “state of exception,” the political science term for the suspension of the rules, ostensibly to restore order.
With market signals suppressed by central bank bond-buying and rates vol suffocated by policymaker forward guidance, price discovery for bonds disappeared almost entirely. By 2019, the fixed income universe was defined by a series of increasingly surreal developments. Entire government curves went negative, for example, and 100-year bonds posted penny-stock-esque returns. Negative-yielding corporate debt was relatively common in Europe as liabilities became assets. There were even instances of negative-yielding “high”-yield debt, the ultimate oxymoron. In early December of 2020, Bloomberg’s index of global negative-yielding debt peaked at almost $18.5 trillion.
Disinflation was the linchpin for all of that. In the event consumer price growth ever returned with a vengeance across the developed world, the “new normal” would be exposed for what it always was: An anomaly. But it was very difficult to see a path to that in the moment. Before 2020, “Wuhan” was an orthoepic error involving Busta Rhymes’s first hit.
The pandemic shattered the calm and exposed not just the fragility of globalized supply chains, but the inherent peril (some might call it naivety in hindsight) of treating “just in time” as corporate dogma rather than one among many strategies for managing supply chains. (When you think about it, JIT’s the strategic embodiment of expecting the best and being surprised by anything else. Cautious types would argue that gets life backwards: You should expect the worst and hope for something better.)
Successive wars in 2022 and 2026 kept supply chains in a state of disruption, prompting rolling bouts of inflation, while efforts on the part of advanced-economy governments to shield households with different sorts of stimulus and subsidies contributed to higher macro volatility. Although we haven’t had another World War, proper noun, the conflicts in Ukraine and Iran, and a prospective fight over Taiwan, feel like dress rehearsals.
Wars are expensive, and the cost of providing for the national defense is set to further burden national budgets already stretched by the legacy cost of the pandemic (and in Europe, of energy crisis subsidies).
The read-across of all this for asset allocators and portfolio managers is that DM government bonds aren’t the low-vol, shock-absorbing assets they once were. They can’t be levered up safely anymore, and they’re not a reliable hedge when it comes to cushioning losses from equities in a risk-off episode. Indeed, government bonds are increasingly a source of risk-off episodes.
And so it was the supposedly inviolable correlation assumption adopted by everyone from local yokel financial planners to risk parity PMs died. These days, you’re at least as safe running a 25/25/25/25 split with stocks, bonds, gold and cash as you are a “traditional” 60/40. Many would argue for 25/25/25/25 split between stocks, bonds, precious metals and other commodities. (“Leave the fiat. Take the wheat from the cannoli shell flour.”)
The higher the incidence of climate disasters, pestilence, mass migration, geopolitical “bloc-i-fication” and war, the less demand for government bonds. This is very, very topical. Indeed, this week’s biggest market story was the US paying the most since 2001 to borrow for three decades.
With all of that in mind, have a look at the figure below, which shows you the 24-week rolling correlation between the S&P 500 and US Treasurys. Why 24 weeks? Well, as BMO’s Ian Lyngen remarked, “Saturday marks 24 weeks since the beginning of the US-Iran war.”
In his weekly, Lyngen noted that the S&P/Treasury correlation illustrated above has been positive on three quarters of trading days this year. “The breakdown of the traditional ‘risk-on, risk-off’ relationship has, in part, been a function of the fact that oil prices have largely set the agenda in financial markets since the war began,” he said.
Of course, it’s not so much oil itself that’s at issue, but rather the ramifications of elevated crude prices — “inflation jitters,” as Lyngen put it. It’s been “encourag[ing] to see the macro conversation slowly shifting away from moves in the energy sector [but] in the event front-month crude [moved] back above $100, calls for greater pass-through risk and an eventual monetary policy response from the Fed [would] intensify, as would the positive stock-bond correlation.”
Coming full circle, the disparity between the Pentagon’s initial timeline for the Iran war (“four to five weeks”) and the conflict’s 24th weekly anniversary is a microcosm of a broader exercise in reality denial this decade.
If you look back across the arc of human history, “transitory” isn’t the right adjective to describe the nature of conflict and inflation. To the contrary: Almost any antonym of “transitory” works better.
And remember: Volatility’s never extinguished altogether. It has to go somewhere.
I refer back to: “Weekly: Buy Gold?”
…but not so sure about the 25% to bonds in the 25/25/25/25 model…
What I just said in the previous post, only better.
Thanks. It certainly is worth stepping back a wee bit and putting things into historical context. Thanks for the reminder!!
One point caught my eye: “With market signals suppressed by central bank bond-buying and rates vol suffocated by policymaker forward guidance”. This is why I differ from you about Warsh’s goal of reducing forward guidance. On August 12th FT, Robert Armstrong touched on the “Minsky-ish” idea that suppressed volatility in the markets is stored in markets in the form of leverage which occasionally gets loose all at once. Armstrong went on to say that he does not believe this but I am inclined to accept the notion.
It’s ironic that Fed guidance which was aimed at reducing uncertainty in the broader economy has been hijacked by speculators in a fashion which may well end up being even more destabilizing than the elimination of dot plots ever will.
Please forgive me for quibbling over a minor reference in your piece.
I’m inclined to accept it too. When I need a good closing line for a Saturday piece with a teddy bear sitting on a burning globe at the top.
I hope that’s not a copyrighted image of a “Build-a-Bear”.
I wouldn’t worry about Build-a-bear, but that bear looks a little too similar to the Buc-ees beaver if you ask me (and Buc-ees lawyers).
“This century’s “Roarin’ 20s” marked a reversion to the historical mean, which looks a lot more like a Hobbesian state of nature than it does anyone’s idea of a collaborative utopia built on universally-accepted liberal democratic principles.”
That’s a great sentence right there.
Reversion may be a hallucination, or at least I hope it is. One thought that has been thrown out is that once someone tastes freedom of thought can they truly go back to the authoritarian? The Magna Carta was built on that principal, which applied to British nobility not their international subjects. The existence of the Magna Carta, so the narrative down this line goes, informed and encouraged the empire to break up violently at times when time was ripe. Who knows as we go back to our bond interest rate and gold pricing charts, paying attention more to the hallucination than human nature itself.
Excellent article. Makes me wonder about the nature of humanity and whether we are a doomed species. So easily caught up by hallucinations of our own making in order to sweep away boredom.
Hypothetically speaking, is it better to approach commodities through an ETF like DBC or through a company like Exxon Mobil? Same with gold: through an ETF like GLD or a company like Newmont? Not intended as advice. Do your own homework. Your results may vary. Batteries not included.
i landed on some KMLM , but as you say ‘results may vary’
My father held gold bars in 2 safe deposit boxes for decades. The annual safe deposit box fees were pretty cheap- as this was a small bank in a small midwestern city.
When I would visit, he and I enjoyed debating the merits of holding gold (He loved owning gold. I don’t.)
After he passed, my brother and I were going to split it and keep it- in honor of our father; however, we learned that there are limits as to the amount of gold one can get through TSA in carryon luggage (which we would have exceeded). So, we took it to the local “gold store” and sold it – at a few points off of the spot.
Immediately after that, gold prices shot up. 🙂
In his final year, I flew to visit him very often. Even as his mental faculties declined, as soon as I would walk into his room, he’d ask me what gold was priced at, then tell me he loved me. He retained his sense of humor (and belief in holding gold) until the very end. He did like to make money from investing. He was also proud of the fact that he and our mom always spent less than their income (he kept records back to the 1970’s).
I always think of my dad whenever H writes about gold. 🙂
Lovely story 🙂
The thing to watch out for is ETF/ETNs which hold futures contracts. They’re fine for trying to time short-term moves, but in the long term, since the notes are structured to neither make nor take delivery, they just wind up rolling their futures position every month. Most futures trade contango over the long run because of storage costs if nothing else, so every roll you expect to take a haircut.
Take a look at UNG (natural gas). Compare that to a chart of spot NG. That tells you everything you need to know about approaching commodities through ETF/ETNs. Gold is unique in that it’s never going to be consumed and storage is surprisingly cheap (maybe not surprisingly. It’s not hard to warehouse inert bricks), so the demurrage is pretty trivial. At the same time, gold miners are wildly volatile and frequently untethered to the underlying. So for precious metals, go ahead and buy the fund. For everything else, just trade the futures directly or stay out. So stay out. You will get run over.
“Take a look at UNG (natural gas). Compare that to a chart of spot NG.”
That’s one of the best cautionary examples. Recently a fellow reader asked about how to trade natgas. I never had done so, but my trading partner for many year had after I decamped to my presnt life. I asked him. His answer was something like”I don’t remember all of the details, but I do remember that I had my head handed to me.” That was from someone who was an even better trader than me! By a wide margin.
I recall that since I had a lot more experience trading in commodity markets he called.and asked me to look at some spot v
versus futures charts. On paper it looked like there might be some juicy carry & carry trades. But it became clear that it was not the case because storage was not an option.
Ah, those hood old day