by Andrew Beer, Managing Member, DBi
In case anyone is interested, here's are some observations about #inflation and #assetallocation.
Higher for longer. What if it’s “higher forever”?
The return of inflation was consistently met with disbelief by the vast majority of allocators. In early 2021, after we wrote a note about Stan Druckenmiller’s prescient call, most allocators confidently told us he was wrong. By mid-year, early signs were dismissed as transitory. By Fall, most expected one or perhaps two rate hikes the following year. During 2022, as the evidence became indisputable, allocators jumped on the idea that the Fed would quickly pivot. By January, the taper trade dominated markets. Then in February, inflation exceeded expectations, short rates rose but longer rates held fast and the yield curve inverted. A few months later, the recession scare post-SVB also was quickly run over by this Teflon economy. Today, the narrative is “higher for longer” – with “longer” simply defined as a “taper” a bit farther out.
Commentators have described this disbelief as a matter of heuristic bias: that humans, used to one state of the world, resist change. We think it is a bit more nuanced. In early 2021, most diversified portfolios were anchored around a single bet: low rates forever. This showed up in both stocks (overweight FAANGs) and bonds (de minimus yields on long dated paper). Research reports and client communications reflected this. Even for an allocator open to the idea of a regime shift, what do you do? No consultant would recommend a wholesale change to a ten-year asset allocation model in year two. An advisor who reflexively dumps all bonds risks, if the data is a false positive, blowing up his or her business. Clients want their professional allocators to be the steady hand at the wheel, and hence most move slowly regardless of whether it is economically rational.
There is a new issue at play, one we did not appreciate in 2021. What if this is permanent? What would this new world order do to “diversified” portfolios? The assumption that stocks and bonds hedge each other anchors trillions upon trillions of dollars of diversified portfolios. Yet there is strong evidence that, when inflation is higher, stock-bond correlations turn positive. This was the state of the world before the past two plus decades. That would upend a cornerstone of asset allocation. Overnight, a back-of-the-envelope analysis suggests a 25% increase in risk in a 60/40 portfolio. Clients who expect a smooth train ride might be strapped on a comparatively scary rollercoaster.
While we have no crystal ball as to how this plays out, we believe allocators should plan for this world. That means increasing exposure to strategies with low beta to both stocks and bonds. The successful allocators of 2030 may well be the ones who embraced, rather than fought, a long-term shift in the market structure.
Copyright © Andrew Beer, Managing Member, DBi
Footnote:
1 "(20) Post | Feed | LinkedIn." 26 Sept. 2023, www.linkedin.com/feed/update/urn:li:activity:7112163211818229760.
