Monday, June 24th, 2013

Rare and Unwelcome

Four weeks ago an event occurred which is fortunately as rare as it is unwelcome. Every major asset and sub-asset class available to US institutional investors produced a negative return. Our extended asset allocation model tracks 11 indices: five equity regions; four categories of dollar-denominated bonds; and two alternatives: commodities and REITs. All of them fell on the week. Last week would have produced a repeat performance, but for a 0.3% gain in Japanese equities. In fact the average decline across all asset classes was significantly worse. Nobody really cares about one week’s performance, but this factoid serves as a reminder of something much more important: equities and bonds can go down together.

In recent years investors have become accustomed to the idea that if equities fall, bonds are likely to rise and vice versa i.e. that returns are negatively correlated. The Greenspan put has been a feature of capital markets for so long that investors find it difficult to remember a time when both equities and bonds could both produce negative returns over extended periods.

There are many ways of measuring this. For the sake of space we will concentrate on a simple definition and look for periods when US Equities and US Treasuries (7-10 years) both produced a negative real return over the preceding 12 months. The last time this happened was in March 2002. Prior to that there were episodes in 1994, 1990, 1987, 1984 and 1981. Most of these only lasted three or four months at a time, and involved single-digit real declines. But the further back we go the more frequent and the more severe they become. There were prolonged simultaneous declines in 1979-80, 1977-78 and there was the carnage of 1974.

To our mind the most interesting episodes are 1980 and 1981, which were brought about by a change in Fed policy under Chairman Volcker intended to squeeze inflation out of the US economy. It is just possible that a successor for Mr Bernanke may decide it is time to squeeze excessive leverage out of the banking and shadow-banking system. Whatever the narrative, it is difficult to see how Treasury yields can normalise without inflicting negative returns on US Equities at some stage during the process.

Let us close with another factoid. March 2002 was also the last time that Cash beat Treasuries and US Equities in terms of its trailing 12-month real return. One hundred and thirty five (135) months have gone by since that date. The next longest run was 62 months. Before the invention of modern central banking, Cash would regularly beat the other two US asset classes, and the interval from one occasion to the next was typically 20-40 months. There are periods when equities and bonds are positively correlated and they both go down at the same time.

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