With interest rates trading at or close to zero percent in most of the developed world, investors have been questioning if government bonds still act as a hedge against periods of market stresses, which are usually negative for equities. One of the most important characteristics of the traditional 60/40 equity bond (and also the ‘all-weather’ portfolio risk parity) has been the negative correlation between equity returns and changes in long-term bond yields. Figure 1 shows that the 3-rolling correlation between US equity returns and the 10Y bond yield turned negative in the beginning of 2000s after being positive for decades (using weekly times series)
However, we are not confident that the correlation will remain negative (implying that bonds are rising when equities are falling) in the medium term, especially if we switch to more inflationary environment after restrictions are lifted. Even though the disinflationary forces will remain significant in the coming 12 to 24 months due to social distancing, investors must not assign a zero-percent probability of a sudden rise in inflation expectations in the future.
Source: Eikon Reuter, RR calculations
Why not swap some of your bond allocation, which currently offers a very limited upside, for gold, which offers ‘unlimited’ upside gains as money supply continues to grow dramatically in most of the economies. Figure 2 shows the performances (and drawdowns) of four different portfolios:
A equity long-only portfolio
A 60/40 equity bond portfolio
A 60/35/5 equity bond gold portfolio
A 60/30/10 equity bond gold portfolio
We can notice that investors would have got similar returns if they had held 5 to 10 percent of gold in their portfolio instead of bonds in the past 50 years. It is time to diversify the traditional 60/40 equity bond portfolio.
Unlike bonds or equities, currencies do not carry any fundamental value and have historically been known as the most difficult market to predict. In our FX fair value model page, we look at different ways of estimating a ‘fair’ value for a bilateral exchange rate. One of the simplest models is based on the Purchasing Power Parity theory, which stipulates that in the long run, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking the account the exchange rates. We know that the OECD publishes the yearly ‘fair’ exchange rate based on the PPP theory or each economy.
Based on the OECD calculations, it appears that the Euro is the most undervalued currency among the G10 world relative to the US Dollar, as PPP prices in a fair rate of 1.42 (implying that EURUSD is 18% undervalued). On the other hand, the Swiss Franc is the most undervalued currency (+26%). Therefore, if we were to believe that exchange rates converge back to their ‘fundamental’ value in the long run, being long EURCHF is the position with the most interesting risk premia among the DM FX world.
In the past cycle, central banks have been constantly intervening in the market to counter the strong disinflationary force coming from the 3D: Debt, Demographics, Disruption. Figure 1 shows that between the beginning of 2008 and early 2020, the assets from the major 5 central banks grew steadily by a annual pace of $1.25tr per year, for a total of $15tr in 12 years.
As a response to the Covid19 shock, central banks just printed more in order to prevent the economies from falling into a deflationary depression, which resulted in a 7-trillion-dollar increase in central banks’ assets in the past 8 months. The titanic liquidity injections resulted in a significant rebound in equities, especially in the US with the SP500 trading over 100 points above its February high.
With most of the European economies entering a second lockdown, and restrictions also expected to be announced in the US (as the elections are now over), governments will again run aggressive fiscal policies and extend the furlough schemes in order to avoid the rise of social unrest, which will result in more money printing from central banks in the coming months.
Is it as simple as this: the worst the economy gets, the better it is for stocks as it will result in more liquidity injections?