AN EQUITY COUNTERWEIGHT
IN SEARCH OF AN EQUITY COUNTERWEIGHT FOR IMBALANCED FUNDS
At the beginning of April, the interest rate market priced the “Japanification” of the USA, as forward interest rates, both nominal and inflation were at levels consistent with low growth and inflation for a very long time (see “Japanification” of the US Rates market now complete).
In the month of April, the US Treasury (UST) increased its debt by $1.37trn, of which $1.13trn was absorbed by the Federal Reserve (Fed). The Russell 3000 rallied by 15% and Investment Grade Credit spreads tightened by 30bps (CDX), and yet 10 year US Treasury (UST) yields were roughly unchanged (Inflation breaks were ~10bps higher and real yields ~10bps lower).
The positive correlation between risk assets (Equity and Corporate Bonds) and “risk free” US Treasury yields drives the whole concept of balanced funds, whereby when stocks decline, profits from declining yields on UST holdings will compensate those equity losses. But when Japanification becomes complete, this whole relationship falls apart, questioning the whole balanced fund concept.
Charts below shows the Nikkei and the 10yr Japanese government bond (JGB) yield during the equity sell offs in 4Q18 and 1Q20, and below the 1 month rolling correlations between the two assets. There are two clear observations:
Whilst the balanced approach worked in 4Q18, it was of no use in the 2020 sell off.
Because of the low JGB yields and the small absolute move in their yields, a huge notional amount of JGBs would have been required to balance the NKY equity holdings.
The charts are similar for Europe – Eurostoxx 50 index and 10 year Eur interest rate swap yields.
The recent lack of UST reaction to the rebound in risk assets is perhaps a sign that the balanced diversification strategy is now a false premise in the US and that the whole concept needs to be reviewed. There have already been other warning flags from firstly the asset price correlation breakdowns in the 4Q18 sell off, as well during the 2019 fixed income rally:
4Q18 Risk sell off: A previous study shows how correlations that held during past equity market sell offs broke down in the 4Q18 equity correction. The interest rate curve, swap spreads and real yields no longer offered a counterbalance to equities, whilst inflation breakevens, gold and AUDJPY did. The same happened in Q120.
2019 Fixed Income Rally: Traditionally interest rate curves - “bear flatten” as rising short term interest rates drive the whole interest rate curve higher. - “bull steepen” as short end rates drive the curve lower when rates are cut.
Below left shows the US 2y yield vs the 2s30s curve, whilst below right the regression between the two between 2000 and 2008 (R2 0.9).
Since 2009, this correlation has declined to 0.59, which is simply because front end rates have been anchored at very low levels and so the long end of the curve has been the driving force of the whole curve movement up or down, leading to curve Bear Steepening/Bull Flattening, the inverse of the previously held relationship.
In the strong 2016 bull run lower in long dated yields, the higher yielding US and UK interest rate curves “flipped”. The shape of the 10y to 30y curve surprised the market in this period, flattening decisively instead of steepening as expected. Both US and UK 10s30s started behaving like Eur and Japanese curves. This was repeated in 1Q20. The reason for this was that the Asset Liability Management (ALM) of Pension and Lifer balance sheets became stressed, requiring new largescale acquisitions of duration to meet enlarged liabilities (see ALM).
This breakdown of equity/interest rate correlations and the US and UK curve flipping behaviour show that interest rate products are in a new paradigm of low rates and stressed financial institution balance sheets. Exactly the same change in behaviour occurred in 1995 in Japan and in 2011 in Europe. This new paradigm begs the question of the value of fixed income in balanced funds, or for that matter other multi asset funds – chart below shows the S&P (blue) and returns of three multi-asset absolute return funds:
WHY INTEREST RATES ARE NO LONGER A HEDGE?
Japanese and European interest rates have been fixed at very low rates for a long time because of their respective debt dynamics, and the monetary and fiscal policy that was enacted to combat those debt dynamics.
There was no quick correction and write off of Japan’s corporate debt bubble. Starting in 1995, the corporate sector deleveraged gradually for 12 years (in some part due to write offs). And despite 0% interest rates for more than 20 years, the Household sector has never increased their leverage. Thus since 2007, the private sector has not increased its debt at all, bringing low economic growth and inflation rates, necessitating large government fiscal deficits to boost GDP. Japan is now clearly in a sovereign debt trap, necessitating perma low interest rates. Rather than continuing to force domestic savings to fund that fiscal debt, which had been depreciating the value of private sector assets, the BOJ decided to start meaningfully expanding its balance sheet in 2011.
European monetary policy has had to deal with two divergent economic blocks. In order to prevent economic collapse in peripheral countries, the ECB has had to maintain very low interest rates. Italian GDP was negative for 6 of the 7 quarters between Dec07 and Jun09, and for 7 straight quarters between Sep11 and Mar13. The Stability and Growth Pact limits the ability of peripherals to follow the Japanese fiscal example, so the only lever available was the ECB’s interest rate policy, which failed miserably as the demand to borrow was limited due to poor economic opportunities (there is a trend here of how zero interest rates does not generate lending, against the doctrines of economic textbooks!!)
Investors started lacking confidence and started selling peripheral bonds in 2011, driving yields higher. The ECB was forced to shore up their debt by expanding its balance sheet buying the peripheral bonds under the SMP program. The ECB used the pretext of using the SMP “to ensure depth and liquidity in malfunctioning segments of the debt securities markets and to restore an appropriate functioning of the monetary policy transmission mechanism”. They used a liquidity excuse for what was a solvency issue.
Crucially, like Japan, the Central Bank balance sheet started expanding with rates stuck at zero. Going forward, using some very conservative assumptions (see here), some European countries will soon find themselves in a debt trap due to the debt increases required to combat the Covid19 economic fallout – crucially, from a political standpoint, this is very likely to include France. The ECB will resist increasing interest rates for a very long time and, subject to the German Constitutional Court, it will have to follow the BOJ and expand its balance sheet to fund the European debt increase to prevent a decline in private sector assets. If they did not, domestic savings would get diverted from private sector assets to fund the government deficits.
A SUBSTITUTE FOR GOVERNMENT BONDS
If long dated government bonds maintain low interest rates and are of little use to protect equity declines (or need huge leverage to do so), then the alternative is surely an asset that
benefits in value when a central bank increases its balance sheet and the leverage in the economy as a whole.
is not impacted by a deleveraging private sector (for example real estate, which has shown to be highly correlated to equity prices due to the relationship between equity and private sector leverage).
For Japan and Europe, the charts below show equity indices, 10year bond or swap yields and the price of gold, with the black vertical line indicating when the BOJ’s QQE and ECB’s PSPP were started (green is the ECB’s SMP). Note:
Pre QQE, the decline of the Nikkei was met by the decline in yields so the resulting JGB price appreciation went some way to balance the equity losses. Post QQE – zero relationship.
The same is true for pre ECB PSPP, where Eurostoxx50 losses were countered by gains from declines in 10 year European yields. After the start of the QE, the relationship died.
What is superbly interesting is the inverse relationship between gold and the equity indices post QQE/QE.
This new relationship makes complete sense when considered against current Japanese and European Fiscal and Monetary Policies. Expanding the money base leads to more of that currency to buy a pretty fixed amount of Gold (or any other store of wealth that is not backed by debt).
Outstanding American and British sovereign and private sector debts are at levels of “over indebtedness”, and forward interest rates are now pricing in Japanification of both countries as bond yields have declined to exceedingly low levels (10yr UST at 0.65% and 10yr Gilt at 0.25%). The financial markets have been given a very strong SECOND confirmation of what future policy will be, the first being the fiscal easing post GFC funded by the “innovative” Central Bank QE.
Due to the Covid19 pandemic, the political decision has been to spend an even larger sum, and “independent” Central Bank decisions, taken much quicker than during the GFC, have been to finance a large slug of that debt through their own balance sheet expansion (out of thin air). This action absolves the private sector from having to fund that debt, keeping asset prices elevated, so the overall leverage in the system is rising – thus the rise in the gold.
Experience from both Japan and Europe show that the balanced fund approach is now invalid in those financial markets. Indeed, where the interest rate allocation of the balanced fund is made to corporate bonds, for the yield pick up against negative yielding government bonds, this will accentuate equity losses due to the correlation between equity and credit spreads.
An alternative “balancing” asset is gold, which performs when there is an increase in the money supply (economic leverage). This in the past might have been where there was an increase in private sector leverage from interest rate cuts, especially when banks substantially increased their balance sheets, but it is also the case where the whole economy leverage is generated by central banks to fund fiscal deficits.
Due to the current state of “overindebtedness” and the expected significant rise in public sector debt due to the Covid19 impact on economies, it seems fair to expect continued further expansion of fiscal policy and even more inflation of Central Bank balance sheets.
If Gold, rather than fixed income, is a better balance to equity holdings in Balanced Funds, then there is a good case for a rotation in their asset allocation, especially given the amount of bonds that yield next to nothing. Should that really happen, then it would be fair to conclude that Gold is rather under owned.