In February 2021, I wrote that the Federal Reserve had created the biggest financial bubble in history because it encompassed everything. Growing inflationary pressures, I said, would burst this bubble as the Fed and other central banks would be forced to act. What I should also have pointed out is that the overall valuation of most traditional securities portfolios, which contain a selection of bonds and equities, was undoubtedly by far the highest in history. . These valuations have been pushed higher by central banks’ reaction to the previous two decades of disinflation and their extraordinary and untimely reaction to the Covid pandemic.
One way to explain what has happened in recent months is quite simple. Inflation has accelerated more than most people expected, especially central bankers. It has already eaten away at real growth, and as central bankers are starting to realize they need to do more to contain it – possibly a lot more, that’s why the Fed has hiked rates by 75bps last week and the Swiss National Bank caught everyone off guard by raising rates by 50 basis points – growth is sure to continue to slump. High and rising inflation and low and falling growth are a toxic combination for bonds and equities when their starting valuations were so high.
But I think other more subtle and powerful forces are also at work, ones that could ultimately take years to dissipate. Prior to the late 1990s, correlations between stocks and bonds were broadly positive—they rose and fell in tandem—because, the evidence strongly suggests, investors worried about inflation. At the turn of the century, they became more concerned about disinflation and growth, and the correlations reversed. As inflation concerns have come to the fore over the past two years, correlations have turned positive again.
This can have significant results, even in the short term. Although the smartest investors try to hedge extreme events by buying very low chance options to protect themselves against extreme scenarios, almost all banks, hedge funds and investment companies rely heavily on a management system. risks in which correlations are a key element. This risk management model is called Value-at-Risk (VaR, for short). At the risk of oversimplifying, if you have two assets in a portfolio, the model will look at the volatility and price performance of those two assets and the correlation between them. If one asset goes up while the other goes down, you get diversification benefits. This means that, for a given amount of capital, a fund manager can have larger positions overall.
But when prices fall, volatility picks up and these correlations change, leading to big losses on both assets when the model assumed a diversification benefit; the investor is forced to reduce his exposure to both assets. It’s called a VaR shock, and I think that’s what we’ve seen in recent weeks: forced selling by investors who suddenly find they’ve exceeded their risk limits. This shock will dissipate when asset prices have fallen enough that longer-term investors are happy to get in. The question of what these levels are is open: each has different measurement or evaluation needs.
There remain, however, at least two longer-term questions. The first, in fact, concerns the cost of hedging risky positions such as equities with government bonds. Correlations say nothing about where two assets end up, only how they get there. Over the past two decades, holding government bonds was the ultimate hedge because, until 2020, the price only rose over time. Investors made money with both asset classes. Since the middle of 2020, however, extreme inflationary pressures in many countries have led to steep losses. I would have thought that unless inflation starts to come down much more than the markets expect, most government bonds still look expensive and ripe for further losses. Either way, how much are investors willing to pay for hedges that don’t work?
The second question is more subtle but perhaps more powerful. When stocks are well-diversified with bonds, demand for both increases, driving up the valuations of each on an individual basis. To really limit inflation, central banks would have to raise rates far more than markets currently expect, pushing countries into severe recessions – the so-called sacrifice ratio. Because I doubt they have the stomach or the political support for it, I think it’s likely that, even if it comes and goes, inflation will persist as a rumbling problem for some time. Since this means that correlations are likely to remain positive, isolated valuations should fall further.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.
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