A Generous Fed Isn’t Really the Good News it Sounds Like
I understand why people are delighted about Powell’s remarks yesterday, about how the Fed would need to see a significant and sustained increase in inflation before hiking rates again. This generation, and the last, does not see inflation as a significant threat, nor a significant cost should it get going, and believes firmly that the Fed can easily squelch it if it gets going. (They believe this because, after all, the Fed told them so).
Older investors might be more reticent to believe that there’s a pony in there somewhere, since the evidence suggests that not only does inflation erode purchasing power (thereby demanding even more nominal return be provided by portfolios that are already overstretched valuation-wise) but it also ruins the diversification effect of bonds relative to stocks. The main reason that 60:40 is a dramatically lower risk portfolio (and more efficient in an investing sense) than 100% stocks is that stock and bond returns have tended to be inversely correlated for a long time. When stocks go up, bonds go down, in general (and vice-versa). But that’s because they have inverse sensitivities to the economic growth factor. In recent years, that has been the only factor that matters, but stocks and bonds have the same sensitivity to the inflation factor: when inflation goes up, both stocks and bonds tend to decline (and vice-versa). Consequently, when inflation becomes an important element in investors’ calculations the correlation of stocks and bonds tends to be positive and in the immortal words of Billy Joel in “Goodnight Saigon,” “We would all go down together.” Along these lines I recently prepared this chart for Real Asset Strategies,[1] illustrating that when inflation is over about 2.5%, correlations tend to flip. This is a 3-year average of y/y inflation (and shown on the chart as inflation minus 2.5% so the zero line is what matters, not the line at 2.5%) versus 3-year correlations; the point is that you don’t need 4% inflation to drastically change the value of the 60:40 portfolio.
I also think that people give the Fed much more credit for their ability to squelch inflation – which after all they haven’t had to do for more than 30 years after spending 15 years squelching the last round – than they deserve. But that’s a ‘show me’ situation and it’s hard to prove my suspicion that they won’t be so successful when push comes to shove.
So, I understand why people are partying about a Fed that is even looser than it had been. I don’t think that’s the correct response, but I understand it.
I also understand why people are somewhat morose about trade frictions. It isn’t for the right reason, that in the long run it will hurt real growth a smidge and increase inflation a smidge-and-a-half, but because they think it will have a drastic effect on near-term growth. That’s why everyone gets so excited about any inkling the US and China are nearing a trade détente and so depressed when it looks like they aren’t. We are told that the current global slowdown is being caused largely by the trade war.
In my view that’s nonsense. The global economy has been expanding for a decade on exceptionally loose liquidity but no tree grows to the sky. The global economy was slowing well before the trade frictions could possibly have had any impact. But it is hard to convince people of that, because everyone knows that:
GDP = C + I + G + (X-M),
or consumption plus investment plus government spending plus trade. And we learned in school about Ricardian comparative advantage and how trade enriches (or anyway, can enrich) both parties at the same time. So if China doesn’t import anything from the US and doesn’t export anything to the US, growth is going to be crushed, right?
But that’s not how trade works. Frankly, that’s not how anything in the GDP equation works. If you remove the final term, you don’t reduce GDP by (X-M). Sure, if this was an algebra problem you would, but it’s not. In the real world, what you lose from trade gets partially replaced by an increase in consumption, investment, or government. Just as I pointed out last year with soybeans, if China buys zero from us it means they have to buy them from someone else, which means that supplier doesn’t have them to sell to one of their traditional customers…who then buys them from us. Incidentally, neither beans nor corn went to zero after mid-2018 (see chart, source Bloomberg, normalized to December 2017=100).
The rest of trade works the same way if the two parties are “internal customers” and “external customers.” Though there will always be winners and losers, if we don’t have international trade then we won’t have a destination for our merchandise overseas…but we will also have consumers who don’t have Chinese goods to buy and so need to buy something from a domestic producer instead. This is not a zero sum game; it clearly results in a loss for all players. But the order of magnitude of this loss in the short run is not very big at all, especially for a country with a large fraction of its domestic production going to domestic consumption, as in the US but not even for the world at large. The world economy has lots of reasons to slow and go into recession, and trade frictions are one of those reasons, but certainly not the only one and not even the largest reason.
An overreaction by markets to anything in a stream of economic news is not unique or new, of course; those overreactions won Robert Shiller a Nobel Prize after all for his work pointing out the “excess volatility puzzle” as an early highlight of the nascent field of behavioral economics. But there’s a good reason to ignore most of these wiggles and focus on the long-term effect of these developments. Which, in the case of both the general climate of trade and the Fed’s reaction function to inflation, are negatives for both stocks and bonds.
[1] As part of Enduring Intellectual Properties’ investment in Real Asset Strategies, I serve as Director of Research for the firm. Real Asset Strategies LLC offers liquid real asset strategies focused on diversification benefits and inflation protection at reasonable fees.
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Thank you for this post. The bond/equity relationship as relates to inflation and other variables remains under-researched and your contribution as per this article is truly welcome. Do you have knowledge of similar research efforts by other analysts?
I am sure there’s similar research out there – I’ve seen plenty about the rolling correlations. It’s the connection to inflation and the realization that this is an expression of the ‘inflation factor’ …I haven’t seen that connection made elsewhere. I’m afraid I can’t point you to anything specific off the top of my head, but you might peruse the “library” at https://www.enduringinvestments.com/library/ and see if you can find something.
Thank you very much. Looking forward to your further incursions into this subject. Also, would love to have your views on a related matter, the relationship between bond and average earnings yield (explored by e.g. Alan Reynolds https://www.cato.org/blog/contra-shiller-stock-pe-ratio-depends-bond-yields-not-historical-averages). Once again, thank you for this blog and your efforts.
It’s an old, and discredited, argument. The question is whether low yields EXPLAIN low E/P (they do, because they’re competing assets) or JUSTIFY low E/P (they don’t, unless yields are in a long-term equilibrium). See Asness on this topic: https://www.aqr.com/Insights/Research/Journal-Article/Fight-the-Fed-Model
Much appreciated. My starting point in thinking about this (being in Europe with, you know, negative yields) is actually the opposite to “justifying low E/P with low bond yields” – it is that the current level of bond yields reflects a very bleak future for European economies and therefore (?) a very weak return potential for equities. There is of course the TINA argument and increasingly it is taken to absurd levels (investors abandoning balanced funds and going for 100% equity at top valuations). Also, the way you phrase it, it begs the question as to how does one define a long term equilibrium. From my bench it looks like Japan is definitely in an equilibrium of sorts and the rest of the Western world appears on the way to similar destination. Low yields, dismal equity returns (if any).
So in practical terms, what quantitative tools (if any) do you use in portfolio construction to account for the prevailing level of bond yields vs. equity valuation?
Love this conversation, thank you so much for you time.
Quantitative tools is just about all I use! I suppose that isn’t quite fair. But I use partly mean-variance optimization with my own long-term expected real return estimates for various asset classes. These days that’s leavened with a little bit of momentum as an overlay. And I should say that in my own investments, I’m optimizing not returns for a unit of risk but net wealth (considering future liabilities). Actually in my book I talk about personal liability-driven-investing. But back to your question, with MVO you’re sort of choosing assets on a competing return basis, so looking at one versus the other (although the degree to which that asset hedges your future liabilities affects its true risk to you). In a low-return world that means though that you then have to pick the level of risk you’re comfortable with and recognize that if the return isn’t “enough,” then you can’t magically create more return…you need to find other ways to accumulate wealth (save more!) to compensate for your expected portfolio return shortfall.
In a nutshell…
OK I should really get your book and dig into it. But if you don’t mind me asking – in very broad terms, disregarding financial liabilities, and in view of current valuation levels, what does your MVO model prescribe for a Euro-based investor in terms of basic bond/equity allocation? I see that Michael Mendelson et. al. of AQR Capital Management in “Asset Allocation in A Low Yield Environment” suggest that low or even negative yielding (?) bonds should be considered for diversification purposes and because “tactical timing has an unimpressive track record”. Is the argument, really, that negative yielding bonds should be preferred to zero-yielding instruments, because, you know, negative yields could become more negative and “timing does not work”? Another way of asking the same question, I guess, is this – what does your long-term expected return estimate calculus say about negative yielding bonds? I can see how there is a clash between “common sense” approach (represented recently perhaps most prominently by Jeff Gundlach) and an actuarial/statistical modelling point of view. Where do you stand in this debate?
Well, we don’t use nominal returns but rather real returns…who cares if my nominal return is negative if the real return is positive? But with negative nominal returns, you’d have to have massive deflation to make it have a positive real return…and there’s just no sign that’s going to happen. And bonds only diversify stocks in low inflation environments – in higher inflation environments they are correlated. So that’s a nonsense view from AQR, although if the argument is that your expected return from stocks is so bad that losing just a little is better, I concur.
I can’t do MVO without knowing what your liabilities/retirement needs etc are, but if you didn’t have any and only cared about asset return then I would say to own very little equity, short- or medium-term inflation bonds, and a decent position in commodities as they are the only truly cheap asset out there. If you’re a fairly active investor then you can hold more equity with, say, a 100-day moving average stop or something, and you could also own equity plus put options which are very cheap right now, but when real returns are negative everywhere things that return zero real (property is a decent example, if it’s not in a bubble, or commodities when they’re cheap…not gold right now though but most everything else) is what you have to deal with.
So for example 5y German ILBs are something like -1.30% real, which means you win compared to nominals if inflation averages just 0.8% over the next 5 years (with 5y nominal rates around -0.5%).
Thank you, this is very helpful. Owning equities with a put option hedge is what I actually have been doing plus in my retirement account I have an allocation to global bonds that I have also considered hedging. I fully appreciate your point about commodities being perhaps the only class worth emphasizing right now but I have no exposure currently and am not sure what instruments to use (can you perhaps advise)? ILB-s are also a new territory to me, will have to look into this.
As regards these negative yielding bonds, what I struggle to understand is what is the cause of negative yields, i.e. is it manipulation by CB-s or is it market driven. We all remember when German bunds yields first approached zero level, certain former “bond king” called it a short of a century. After a bounce, yields kept falling, what is more, they made new lows even after ECB had stopped buying them. There was never a meaningful bounce the entire time ECB was out of the market. Now what does this mean. Bond markets being the “smart money”, are we really looking at outright deflation in the Eurozone? Or is it perhaps a kind of a negative feedback loop introduced by ECB aggressively cutting rates and tightened regulation plus weakened capital cushion from the GFC that ended up weakening the banking sector so much that they could not trust each other so the funds needed to be parked outside of the banking system even at the cost of earning a negative yield on alternatives. So big customers of these banks end up comparing the cost of insurance (CDS) on banks against bund yields and voila, we have negative yields. Kind of makes sense to me but funny thing, as much as I have looked, never found good insight into this. But what about Japan then? Do you have a view on that? Do you, as an “inflation guy”, not find this subject to be very intriguing, to put it mildly?
Really appreciate your insight and advise.
Well, negative nominal yields obviously don’t make any sense in lots of ways (find my article here entitled “Wimpy’s World” for my take on that). A lot of it is forced buying, institutions which are required to own bonds even if the prices are wrong. As for commodities, I wrote about the USCI ETF when it first came out, that remains my preferred until we launch ours (or if you get a private manager like me to run it). SDCI is the non-K1 version, also lower fee, but surprisingly most of the volume remains in USCI.
Thank you Michael, for you insight and perspective, really appreciate it!