Global investors are caught in a perfect storm.
The huge slump in the value of equities gets all the headlines and, in fairness, the US stock market is suffering its worst start to any year since the Great Depression with shares on the S&P 500 down 22.3pc on a total returns basis.
But, incredibly, things are even worse in the bond market. Benchmark 10-year US Treasury bonds are on track for their worst first six months of the year since 1788. It's a similar story in most developed markets.
That has huge implications because it means investors are left with nowhere to hide. There is also very little precedent to help predict how they might react.
It is extremely rare for the two main asset classes to fall in tandem like this. Since the 1990s, shares and bonds have been “negatively correlated”, which means that when one goes up the other goes down and vice versa. Indeed, there have only been three years in the past century when bonds and equities both lost money.
The vast majority of retail and institutional investors start building their portfolios from the same basic starting point: they invest 60pc of money in shares and 40pc in bonds. Of course, no two portfolios are identical as investors all have different goals, risk appetites and time horizons. However, the 60/40 equity-bond combination has long been viewed as the model template for a well-diversified investment strategy.
Want some capital appreciation? Of course you do, and that comes from investing 60pc of your money in equities. But you could probably do with a little income and some risk mitigation too, right? Well, that’s provided by a 40pc allocation to investment grade fixed income.
The 60/40 portfolio is the Morecambe and Wise of investment strategies, the burger and chips, the Run DMC ft. Aerosmith — a perfect combination of yin and yang that allows the differences of the two sides to accentuate each other's attributes so that the whole is far more than the sum of its parts. Analysts reckon that, all in, about a trillion dollars is invested along these principles. At the moment, almost every single cent of that money is hurting.
It isn’t supposed to be this way. In a normal downturn, central banks will cut interest rates in order to try and kickstart the economy. This will result in bond yields falling and bond prices, which move inversely to yields, climbing. A 60/40 portfolio is therefore the financial equivalent of leaving the house with your sunglasses and umbrella — you’re covered whatever the weather.
Well, almost any weather. We’re currently in the midst of what may well turn out to be the worst quarter for the 60/40 strategy in decades. Analysts have calculated that a model portfolio will be down about 14pc since the beginning of April. That’s a worse performance than during the financial crisis or at any point during the pandemic, according to data compiled by Bloomberg. The rout is so bad that Goldman Sachs Asset Management recently read the last rites for the strategy and declared it dead.
The normal rules don’t apply because this isn’t a normal downturn. Interest rates have been close to zero for the best part of 15 years since the financial crisis. Massive amounts of money printing through quantitative easing has pumped up the prices of a whole range of assets. Now, central banks are raising rates in order to try and tame inflation at the same time that the economy is heading towards a possible recession.
There have only been three years in the past century when bonds and equities both lost money. The first was in 1931, when a currency crisis resulted in the UK being forced to abandon the gold standard; the second was in 1941, when the US entered the Second World War. Needless to say, these were pretty seismic events.
The third time was in 1969. That was when the US Federal Reserve, after letting prices spiral out of control, finally switched into inflation-fighting mode. Interest rates went through the roof. It worked and price rises started to slow but not before the economy had been pushed into a steep recession. The lack of growth combined with sky-high rates resulted in a period of negative returns for both equities and bonds.
We appear to be staring down the barrel of something similar. Inflation has become a risk that is too big to hedge. The longer it stays high, the longer bonds and equities remain positively correlated with their prices falling together. This will cause investment models, which had assumed a diversification benefit, to start flashing red. All other things being equal, that will result in investors having to reduce their exposure to both of the main two asset classes, which will, of course, further accentuate the sell-off.
On Wednesday, Jay Powell, the chairman of the Fed, warned further surprises on inflation could be in store. Global central banks created an everything bubble; now we’re getting the everything bust and wealth destruction on an epic scale.
This all suggests that the standard hedge against a downturn is completely kaput. Investors are desperately searching for new ways to protect themselves. BlackRock, the world’s largest investment firm, has suggested one way would be for investors to allocate more money to strategies that both go long and short equities.
Well, up to a point, Lord Copper. What might make sense for individual investors could have profound and unknowable consequences for the market as a whole. There’s nothing inherently wrong with shorting shares and making money if the price falls (regardless of what the governor of the Bank of England has said on the matter in the past).
But what will happen if a big chunk of the roughly trillion dollars that is invested in 60/40 strategies starts betting against a broader array of stocks — especially in the midst of a falling market? I guess we may soon find out.