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Holly LaFon
Holly LaFon
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Ben Inker's 1st Quarter GMO Letter: Is Investing Starting to Get Difficult Again? I Hope So

In the first three months of 2018, volatility rose and correlations between stocks and bonds shifted

May 15, 2018 | About:

Executive Summary

In the first three months of 2018, volatility rose and correlations between stocks and bonds shifted. In other words, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years than the very low volatility and strongly negative stock/bond correlations of more recent memory. The change, albeit only over a short period, should have investors evaluating whether the “easy” environment that we’ve seen through this bull market will continue. If it does, the returns we “deserve” to earn as investors should be low. If not, we can hope for a bumpier but more profitable future in the long run. Which path will the future take? My money is on the latter. As Herman Minsky put it, “Stability breeds instability.”

Is Investing Starting to Get Difficult Again?

I Hope So

Ben Inker

For the last eight years, investing has seemed to be a pretty easy activity to most observers.1 Not only have markets given strong returns, but the apparent riskiness of both individual assets and overall portfolios has been low. It has not simply been the lack of giant, horrifying market dislocations that gives the impression of low risk, but the combination of very low general market volatility and an extremely friendly correlation structure such that stocks and bonds have been wonderfully diversifying. For most investors, this has been a happy combination. For those investors targeting a given level of volatility, whether through risk parity or otherwise, it has been a license to lever up their exposures significantly, to generally good results. Last quarter, investing started to seem a little harder. Not only were returns to most assets mildly negative, but volatility rose and correlations shifted. That’s a good thing, probably a necessary thing if investors are to achieve their long-term goals. On the other hand, we’ve only started the transition from easy to hard, and that path is, almost by definition, not a pleasant one. Investing is often a case of “be careful what you wish for.” “Easy” is fun in the shorter term, and the shorter term can go on for a surprising amount of time, but it winds up being self-defeating. “Hard” is, well, hard, and it’s hard to like things that are hard. Personally, I’m hoping for a return to hard. Not only should it lead to better long-term returns to investors, but it is also a good deal more interesting. Maybe last quarter was a blip and we are going to go back to “easy” for a while longer. If determining when easy turns to hard were easy, well, hard wouldn’t be as hard. But portfolios built for “easy” are poorly designed for “hard.” If conditions prevailing in the first part of this year persist, asset valuations will very likely have to fall, and the process could become disorderly if levered positions have to be unwound reasonably quickly.

So, what is investing again?

A decent working definition of investing is deploying capital to perform an economic function for which some rational counterparty is willing to compensate you. That may seem like a pointlessly broad definition, but in reality, keeping it in mind can really help you determine whether an activity is actually “investing” in the first place, as well as how much you should expect to make from an investing activity. The investing world is not perfectly efficient, and a counterparty might have different goals and incentives than you predict, but even still I think it’s a surprisingly helpful framework. Some ways of using this framework are discussed in the paper “Back to Basics”2 from a few years ago, but I’d like to relate it to “easy” and “hard” in recent market conditions.

Equities should give a risk premium over bonds and cash in the long run due to a combination of what they mean for the issuer and what they mean for the buyer. For the issuer, equity is the lowest-risk capital he or she can raise. It never needs to be paid back, has no contractually required payments, and can never drive a company into bankruptcy. In return for this low risk, rational issuers should be willing to pay a higher long-term cost than they would for “riskier” capital. For the purchaser, the same features that are positive for issuers make equity riskier than other ways of providing capital to a company. But it is not the idiosyncratic risk of an investment gone wrong that explains why stock investors should demand a decently sized risk premium. It is the correlated risk. Given the cyclical nature of the economy and the fact that corporate profits are the most volatile major constituent of GDP, most equities will tend to do badly at the same time. But even that doesn’t justify an equity risk premium anything like as big as we have seen historically. It is the fact that equity losses will occur at just the time that is most painful for the entities that own them. And that is the key. A portfolio does not exist in isolation. For almost all investing entities – whether an individual saving for retirement, a corporate or public pension fund, an endowment or foundation, or a sovereign wealth fund – the most crucial risk is the risk of losing money in the portfolio at the same time that cash flow from other activities is drying up. Losing money in your portfolio stinks. Losing your job stinks more. Losing money in your portfolio at the same time you lose your job is even worse, and that correlation is what makes “risk assets” risky. While an endowment or sovereign wealth fund can’t lose its job in the same way an individual can, talk to a development officer or tax collector about what happened to cash inflows during the financial crisis, and you’ll find that the impact is analogous.

So where do “easy” and “hard” come in? Let’s imagine I told you that economic downturns were avoidable and governments could act in ways that all but guaranteed that they would be brief and minor events. What would that do to the risk premium you’d require from risk assets? If you were a company needing capital, what would that do to your choice of what kind of capital to raise? For the buyer, believing that downturns would be infrequent and shallow would make you demand less of a risk premium to buy equity. For the issuer, despite that smaller risk premium, you’d still generally prefer a higher debt to equity ratio than you would otherwise.3 Actually, this framing helps explain what is otherwise an odd feature of recent corporate behavior. At a time when the cost of equity is low both relative to history and the current return on capital, why have companies been issuing debt and buying back stock instead of issuing stock to raise capital? If corporations believe that downturns will be uncommon and mild, they will rationally respond by shifting their capital structure away from expensive but safe capital (equity) into cheaper and riskier capital (debt).

Arguably, the height of this behavior has not been the last few years, but rather the years leading up to the financial crisis. Back then, the “Great Moderation” had many investors convinced that economic downturns simply didn’t happen anymore. This led to the most extreme mispricing of risk that we’ve ever been able to see in financial market history. While previous bubbles brought individual assets to price levels far more extreme than what was seen in the run-up to the financial crisis, the general risk/reward trade-off was farther from “normal” than anything we have ever seen. Exhibit 1 shows a return/volatility scatterplot from our asset class forecasts as of June 2007, along with a regression line showing the general relationship.

The slope of the line should be positive – riskier assets should be priced to deliver higher returns. But the Great Moderation changed investor perceptions of risk such that the slope went strongly negative.4 The financial crisis obviously came as a horrible shock to that mindset, but the rapid recovery in corporate cash flow in the aftermath and the consequent lower levels of distress than previous cycles experienced have served to assuage investors’ economic concerns. The passage of time has also dimmed the memories of the pain of the crisis, such that most investors seem to believe they would stay the course through another such crisis, whether or not they held their nerve last time.

But there is another feature of markets since the crisis that has exacerbated the impact on financial markets. Not only have fears of economic downturns receded again in the minds of investors, but it has seemed easier than ever to protect portfolios even should something bad occur. Risky assets are risky because of when they will lose you money.5 There is an asset, however, that is likely to cushion the blow at that exact time – high quality bonds. Two important things tend to happen in depressions that are helpful to bonds. First, inflation tends to undershoot expectations as demand disappoints. And second, central banks generally ease monetary policy, lowering rates in real terms to stimulate the

economy. Both of these accrue to the benefit of high quality bonds, and owners will receive a windfall from their bond holdings in a depression, which can mitigate losses suffered elsewhere in the portfolio.

The fact that bonds also tend to give a better return than cash helps explain why bonds are a mainstay of all but the most aggressive portfolios, and, to an extent, helps explain the appeal of risk parity strategies. High quality bonds did their job in the financial crisis. But what is more surprising is how astonishingly well they have done their job since then. Despite the fact that stock markets and bond markets have simultaneously rerated since 2009 – that is to say their valuations have risen substantially – the correlation between stock returns and bond returns has been more negative than at any time in history other than the Great Depression. We can see that clearly in Exhibit 2.

Through most of the last 150 years, the correlation between stock and bond returns on a monthly basis has been positive, averaging a little under 0.2. This is a low enough figure to mean that they usefully diversify each other, but not in a hugely impressive way. The last decade, however, has seen a profound shift in this relationship, with the correlation dropping to -0.64, with the last five years a still stunningly low -0.55 despite the fact that no bad economic events have actually occurred. This is actually a monumental shift. With a correlation of 0.2, adding bonds to a stock portfolio increases the volatility of a portfolio relative to using cash for your low-risk asset. At -0.55, adding bonds to your portfolio sharply reduces overall portfolio volatility, as can be seen in Exhibit 3.

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About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

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