Simple models, and some portfolio conclusions
There’s lots of conversation about inflation being transitory. It is still very much the case that markets are pricing a view more akin to the low growth, low inflation, and low rate environment of pre-2020.
Firstly, let’s review real rate risk-neutral models from output gaps. Rates would be much higher if the output gap was expected to be (or proved to be) persistent.
That model, by the way, comes from regressing the output gap, as a percentage of GDP, against the real risk-neutral rate, which is the estimate of the average future short rate adjusted for the term premium and inflation.
The same conclusion holds from simple inflation to nominal yield models. The 2020 track is very different to the years in which inflation was unanchored. Otherwise, at circa 5% CPI, you’d see nominal yields vastly higher.
And it is the same with nominal GDP forecast growth estimates.
The three graphs lead to the same conclusion: “the market thinks inflation is temporary, and secular stagnation (or at least lower growth, lower inflation, and lower rates) is what we should expect.”
The counter view, of course, is if you think the bond market is wrong: rates are set to rip further, and hold on to your hat as your 60/40 portfolio implodes. We don’t share that view, but clearly some participants expect it and are positioned for it.
There’s an additional conclusion to be had here. We didn’t think inflation would prove as persistent as it has or be as high as it has been.
COVID stuck around far longer than we expected (which decreases labour supply), and monetary and fiscal policy were more stimulatory for longer than we expected (which increases demand).
We also didn’t expect the UKR-RUS war, which exacerbated supply chain woes, and we expected that the magic of markets would de-bottleneck supply chains quicker than it has.
All of that meant aggregate demand was higher and aggregate supply lower than we expected, which resulted in higher inflation than we expected.
As such, we held quite a bit more fixed income, as a proportion of a balanced portfolio, than we would have, had we successfully predicted all of those things. We were underweight, but not by as much as we could have been.
And we started narrowing that underweight when yields reached 2% (from 0.50%), thinking that we were most of the way through (as in, through the repricing of yields to a more appropriate value reflecting the exit from emergency policy settings).
As we know, Aussie 10s ran all the way to 4%. We thought 4% represented great value and were adding there too. Had we realised how stubborn inflation would prove we would have kept our underweight lower to that point.
The good news, I suppose, is that seemingly every other manager did the same thing. Our returns are about the same over the last quarter, for our balanced portfolio, as the median manager, and are better than the benchmarks (e.g. the vanguard balanced portfolio), meaning that a) active management added some value, and that b) it didn’t cost relative performance.
Our direct equity sleeve was well positioned, given it has more levers to pull (there, after all, 200 stocks to choose from), and our performance over the past year is amongst the very best in the business.
But returning to our starting point: I suppose if you’re going to be surprised by a bunch of outcomes, that’s definitely not a terrible result.
Let us marry the conclusions from the first and second parts of the note, to think about inflation, again, and what positioning should look like moving forwards.
It still looks transitory! The market has not priced in high and persistent inflation. Nor is it positioned as such.
The models above suggest that things are different from the 1990s or 1980s.
And now, looking forwards, we find the Fed hiking policy into an already inverted yield curve. It is unlikely, given this inversion, that further Fed hikes will cause the ten-year bond rate to rise meaningfully (which is the backdrop that so befuddled Greenspan during the mid-2000s “conundrum”). In other words, we expect that should bad news manifest, yields will likely fall rather than rise, whether that bad news is the Fed tightening itself or just the resultant economic slowdown.
The defensive part of the portfolio should be defensive so that if things go badly they give us plenty of firepower to buy (now cheaper) risky assets.
Should things muddle through, and the Fed doesn’t accidentally induce a recession (or just that global growth stabilises), then it is likely risky assets will do just fine, and we’ll have a much higher carry on the bond portfolio to boot. That’s good!
Maybe the way to wrap up is that it seems we are through the worst of it. The ex-ante returns on stocks and bonds are quite attractive, and the ex-ante correlations between them should return to negative.
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