Eighteen months ago we authored a piece on the changing dynamic between stocks and bonds. Specifically, we noted how the negative correlation that investors had grown accustomed to following the 2008 Financial Crisis was in danger of reversing, and how this would require integrating new and diverse return sources and capital protection tools to navigate a more volatile market regime.
When we wrote that piece in November 2020, the VIX hovered around 15, the yield on 10-year Treasuries was roughly 80 basis points, and the Nasdaq Composite Index had risen 70% in eight months. All seemed right in the world. “Buying the dips” in equities was continuously rewarded while the “flight to quality” benefit from bonds had become the standard. Diversification and non-correlation were merely hindrances to maximizing profits, aided by the trillions of dollars flowing into the capital markets from an ever-accommodating group of central bankers.
Fast forward to today, and equity market volatility has doubled, the 10-year UST yield has crossed 3.0%, and the Nasdaq is down nearly 25% from its recent peak.1
While investors continue to grapple with one of the worst starts to the year for publicly traded equities in decades—the S&P 500 is off to its worst start since 1939—the more problematic challenge is in fixed income, with the U.S. Investment Grade Corporate Index falling almost 13%, nearly 2.5x its record calendar year drawdown dating back to 1974.2 Worse yet, these precipitous declines are happening simultaneously, leaving most traditional “60-40” portfolios nursing double-digit losses in 2022.
Investors are now acknowledging that the excesses in both stock and bond markets were fueled by “free money” in the form of monetary stimulus combined with near-zero interest rates. And if money is free, then why not maximize risk to maximize potential returns? This is the mentality that can develop when the U.S. Federal Reserve (Fed) expands their balance sheet by 10 times in just 14 years.
As brutal as markets have been so far this year, we have only scratched the surface of changing policies in terms of rising rates and the shift from “QE to QT.” Meanwhile, traditional metrics like stock market valuations and credit spreads, having retreated from their recent peaks, are still in “high-risk” territory. So, what should investors be doing now?
We continue to see the benefits in non-correlated strategies like discretionary macro, quantitative trading, and diversified, multi-strategy investing to protect capital (assuming the role of fixed income) and drive returns (in lieu of relying on long-only exposure to public equities). These macroeconomic periods of higher inflation, rising rates, and geopolitical uncertainties, if history is any guide, tend to be more secular than cyclical; in such environments, diversified portfolios can prove far more durable.3
While the future is always uncertain, it does seem that outcome distribution “tails” have widened dramatically in the face of myriad uncertainties, and that includes the actions of policy makers. Back in 1979, Fed Chairman Paul Volker said, “The standard of living of the average American has to decline. I don’t think you can escape that.”4 To date, central bankers have yet to offer such a gloomy, if perhaps necessary, prognosis. But a multitude of factors, including liquidity conditions worsening, rates increasing, volatility rising, valuations falling, credit spreads widening, and geopolitical risk rising, suggest that diversification is once more a prerequisite to navigating the next market cycle.
(1) Source: Yahoo Finance, as of June 8, 2022.
(2) Source: Wall Street Journal, as of June 8, 2022.
(3) Source: Macrotrends and iCapital analysis, as of May 1, 2022.
(4) Source: New York Times, “Volcker Asserts U.S. Must Trim Living Standard,” October 18, 1979.
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