"Chances of a repeat of last year's poor performance are low. [But] we're entering an era of higher market volatility. And that has implications on the 60/40 as well." -Wei Li, Black Rock Global Chief Investment Strategist.
It seems like déjà vu. Again, the partisan infrastructures of both major parties are posturing for a debt ceiling fight. With little prospect for serious negotiation and US political polarization at a highly elevated pitch, CDS markets had begun reflecting investor anxiety over a week ago.
Now, some market luminaries are warning that we could be entering a more ominous phase defined by panic. After the worst year for the 60/40 portfolio in recent memory, this and other risks have particular significance for many investment managers.
While historical odds imply a reversal of the extreme conditions that led to the dismal performance of the 60/40 portfolio, the debt ceiling is one risk where unfavorable resolution could quickly test that theory. And what is it they say about past performance and future returns again?
Is it different this time? Washington insiders who may lack diligence in many areas are absolutely Spartan in their adherence to a consistent regime of procrastination and kicking the can down the road.
Thus, a false Boy Who Cried Wolf confidence that matters must certainly be resolved this time, just like the time before and the time before, could prove disastrous. And to be clear, the debt ceiling will likely be raised again this time. But copious secular risks in a post-COVID world are waiting to take the debt ceiling's place at the fore of the market's list of headaches.
It's important to remember how central US debt is to the functioning of modern financial markets. For example, without stability in this core global asset, it's difficult to ascertain the value of hundreds of trillions in derivatives contracts. The primary liquid asset comprising bank capital is US treasuries.
We all go down a frightening financial rabbit hole if we can't count on US debt (the risk-free asset) for practical and conceptual functions underpinning global capital markets. There's certainly a lot to talk about around the debt ceiling. One more obscure but practically important consequence of a US default would be the devastating hit on pensions, 401k accounts, and all manner of investments.
A worst-case scenario would likely lead to the simultaneous sell-off in stocks and bonds that undermines the relationship at the heart of the stalwart 60/40 portfolio's success: the negative correlation of stocks to bonds. And worst of all, that's just one of many risks that could produce such an effect this year:
Escalation in Ukraine or Taiwan
Fed Policy Error
Banking Crisis Worsens
Return of Inflation
CRE meltdown
Write-downs of Private Assets
Any potential risks, which continue stalking markets as we approach the halfway mark of 2023, could lead to the type of panicked sell-off where all correlations move toward one. Where skedaddling with as much cash as you can grips market participants at the expense of reason and order. Furthermore, some of the risks do bear similarities to the period known as "The Lost Decade," where performance for the portfolio was poor over a sustained period.
Key industry participants are divided on whether the 60/40 portfolio can survive the likely period of secularly elevated volatility we currently find ourselves experiencing. And while it is a great cocktail conversation, the consequences of the debate are very prodigious. Retirements depend upon it.
Blackrock postulates that the portfolio was built for more manageable times, and the risk environment will erode the level of returns compared to historical levels. On the other hand, Goldman Sachs postulates that no strategy won't have occasional bad years but that the underlying assumptions and structure should be resilient even as core market drivers change.
Higher bond yields in 2023 could help the 60/40 stabilize after a horrible year. Of course, bonds could definitely have an even worse year than 2022 if Uncle Sam's creditworthiness suddenly diminishes in the eyes of the world after a costly and embarrassing default.
Another Potential Wrench in The Gears: Politicized Pensions
Of course, for those in the financial services industry, the kabuki of political wrangling is not the concern but the practical effect of a potential US default. Industry decision-makers think of the standoff through the lens of how it could affect their capacity to deliver to clients, investors, or pensioners.
In the face of growing domestic political polarization and an increasingly intense super-power standoff, many of the key factors driving the success of financial markets over the past decade and a half appear to have withered away. Federal Reserve policy has likely also encouraged excessive risk-taking over the last decade. We'll probably discover who's been swimming without their proverbial shorts in the coming quarters.
It's not just the high-drama risks like the debt ceiling. The growing politicization of state laws around investing can complicate the investment operations of pensions. It may prove a pernicious obstacle that compounds other problems pensions are facing.
On the global front, matters could be better; conflict is rising worldwide, as is the fragmentation of the global economy, and when these factors converge in history, it tends to raise costs and erect barriers to trade. This can pressure margins, particularly for multinationals accustomed to a more free-wheeling environment.
The Just-In-Time supply chain is starting to return in some industries and is slower to return in others. Still, inventory volatility can be subject to a bull-whip effect that makes earnings less certain and, correspondingly, the jobs of financial analysts harder.
Ultimately, the 60/40 portfolio's success depends on the equity portion to drive returns. The last decade had many factors juicing equity returns that are now absent, suggesting the next decade could see lower returns for stocks. And aside from the current debt ceiling issues that might dramatically affect bond valuation, even if they are resolved in the most favorable market scenario, the Triffin Dilemma suggests they will continually return.
And then, of course, the strange demand patterns caused by COVID have made it much harder for qualified investors to orient themselves as to where we are in the economic cycle — which is often one of their key advantages over less sophisticated market participants. Many decision-makers at pensions and other funds are feeling their way through a 2023 risk minefield in the dark.
Inflation: Down but Not Necessarily Out
So, despite recent Fed progress on inflation and the prospect of a pause, the global geopolitical risk environment suggests that inflation could be a lingering concern. That's even if you have full faith in the Fed's competence.
War, which unfortunately is making a real comeback, tends to produce higher costs for commodities and international trade barriers, augmenting inflationary pressure. Dr. Ed Yardeni summarizes this historical tendency as the Tolstoy Theory of Inflation (War and Peace).
We tend to have a myopic focus from Fed presser to Fed presser. Focusing on changes from minute to minute in prices as Powell answers questions. However, it bears remembering that when inflation was last this severe four decades ago, the Fed required successive efforts to get it down, ultimately culminating in the only rate-hiking cycle more severe than the one we are likely at the twilight of.
Market gains and optimistic earnings projections for 2024 largely depend on the Fed's vanquishing inflation. Any reprieve gained from an announced pause would be more than given back if the market suspects the Fed is losing control and the prospect of a wage-price spiral materially increases from recently diminished levels. Such a situation could be one vicious commodity price spike away.
Why the Debt Ceiling Crisis is Anathema to the Most Popular Portfolio in Finance
The particular significance of a US default for the financial industry is that the 60/40 portfolio is already coming off of one of its worst years in history. And dark clouds seem to be gathering instead of things looking bright for the time-tested portfolio concept. The ongoing debt ceiling fight is just one of many risks that suggest those who persist in sticking to an unmodified 60/40 allocation will continually find that the assumptions underlying its success over the past decades appear more and more tenuous.
One surefire way to hit the Achilles heel of that strategy again is for the US to default on its debt, as this would likely cause the typical inverse correlation of bonds and equities to move back toward one, as it did for much of 2022. But growing trends toward domestic industrial policy, hardening supply chains, and economic ostracization could all cause increased volatility, anomalous correlations between bonds and stock, and diminished stock returns.
In other words, the debt ceiling standoff is not just one temporary catalyst. It is emblematic of a larger trend toward more significant government intervention in the economy that tends to vex stocks as an asset class, whether on the monetary or fiscal side. With Zero-Interest Rate Policy (ZIRP) gone, the training wheels are off for a generation that sees the ugly face of inflation for the first time. The equity gains of the last decade have primarily been based on future earnings that will now be more heavily discounted.
Furthermore, a reversal of the economic liberalization and globalization that occurred over the last decades and helped underpin exceptional gains in financial markets and corporate profits has likely begun in earnest.
With dollar strength, increasing government scrutiny of business, and a more challenging international operating environment, profit expectations are likely too high on a short and medium-term basis. Uncle Sam has been unusually accommodating to business in the last decades, but now he's focused on acrimony at home and abroad.
The consequences could be far-reaching for the financial services industry. The forces that led to stocks and bonds being mostly inversely correlated over the last decades may be more temporary than we collectively suspect. If this is the case, those who innovate ways to avoid the adverse performance consequences of volatility and drawdowns will outperform, and those who do not will lag.
Is the Problem Also the Answer?
"A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities concerning a wide range of contingencies." -Harry Markowitz
Those clinging to stringent orthodoxy on Mr. Markowitz's iconic portfolio seem myopic. The more considerable insight underlying his theory suggests that if a better mouse trap can be built, it absolutely should be. The proliferation of diverse and precise instruments for mitigating risk adds to the viability of the time-tested skeleton of the 60/40. Of course, they can be hard to use, and timing is vital.
Still, in the spirit of Markowitz's quote above, integrating additions and tweaks to boost performance by better avoiding the drawdowns that are deadly to fund manager performance seems particularly valuable in today's high-risk environment.
Black swan risks are always low-probability events. Recency bias always inclines humans toward understanding events through the prism of the past, which can obscure the probabilities of unexperienced low-probability events. But sea changes in the investing world can leave once-safe strategies providing only superficial comfort.
When underlying realities of international law and cooperation at the heart of economic growth for the last seventy years change, they can also undermine core assumptions that underpin debt markets — both for sovereign and corporate entities.
When market indicators show real consequences in areas like CDS insurance, it's enough to keep you up at night if you're responsible for the livelihood and retirement income of thousands or tens of thousands of people. The fact that Washington considers default more likely than Wall Street, according to Bloomberg, is also particularly disconcerting.
Of course, there are many apocalyptic renderings of what could happen should the country default, and they should not be taken lightly. One probable outcome is that it would cause bonds and stocks to fall in unison. There are many unknowns if the event were to occur, but another year where simultaneous price movement from stocks and bonds in the same direction could start a process that ends the dominance of the 60/40 as we know it.
There is, however, a common factor in the occurrences when the correlation of stocks and bonds tends to move toward one. It happens during periods of elevated volatility. Of course, inflation has played a role this time and at other times when the 60/40 portfolio has been weak. Thus, adding commodities or inflation-hedged assets to a 60/40 allocation could be a solution.
But the debt ceiling risk challenges even this approach. It's reasonable to assume that commodity prices could also fall with stocks and bonds in the event of default.
However, Markowitz's original insight that underpins the portfolio, which enabled a better quality of life for countless folks, is that non-correlated assets provide the key to diversifying risk to ensure an efficient return profile. What always rises when stocks and bonds fall in unison amongst fear and gnashing of teeth? Volatility does.
So, ironically, the answer to the elevated volatility surrounding global events and financial market catalysts that imperil the 60/40 portfolio's trademark stability could be volatility itself. Monetizing and isolating it has great potential to boost the efficacy of Mr. Markowitz's prosperity pill. Cleverly and competently using liquid volatility strategies can inject new life into the beleaguered 60/40 portfolio, boosting returns and lowering risk.
