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Good morning. A bad day for stocks yesterday. The blame was placed on the bad reading in the Conference Board Consumer Confidence Index. However, this is more like a market looking for an excuse to sell. For better or worse, the market half-life of economic data is currently measured in hours. Write to us with measured, reasonable, long-term views: email@example.com as well as firstname.lastname@example.org.
Cost of a short term loan?
While working on a letter yesterday about long-term corporate loans, I spoke with Jim Sarney, CEO of Payden & Rygel, a good friend of Unhedged. He hit the table a little, saying that I had the opposite: the real opportunity was in the short and middle part of the curve.
“It’s attractive from a simple point of view, where the hell can I put my money right now, be it an organization or a private investor,” says Jim. “And it can be enjoyed no matter what one’s opinion is that we are facing Armageddon or we will be fine.”
The argument looks like this. A portfolio of investment-grade corporate securities with an average duration of about 2.5 years provides a yield of 4 to 4.5%. “On the back of the napkin,” Sarney says, “that means Treasury yields could rise another 180 basis points or so before the overall return for the investor goes negative.”
The two-year Treasury, roughly reflecting the expected peak in the federal funds rate, yields 3.1%. Suppose it rises to, say, 4.6%. Now your basket of mid-term corporations is barely breaking even. But under these circumstances, stocks and long-term bonds are likely to perform much worse than break-even ones. Losing just a small amount of money can make you feel pretty good. And if rates fall (or spreads narrow), there will be bonus returns along the way.
The CPI, of course, is 8% or so, which makes the yield half as attractive. Sarni doesn’t stop: “You have to be somewhere. Eight percent is not a long-term figure. Decreases by 8 percent. During the life of this portfolio, inflation will not approach 8 percent – north of 3, south of 4, maybe? Sarney believes that, given the tangible slowdown in the economy, when the Fed is only halfway to the expected target, the bet is on lower inflation and rates. And if the Fed pushes the economy into a hard landing, you could do worse than owning the debt of companies “that will weather the storm just fine.”
As an example of the portfolio that Sarney is talking about, you can look at, for example, the corporate ex-144a Ice BofA index 1-5 years (yield to worst 4.25%, average duration 2.7 years); or the US Bloomberg corporate bond index with a maturity of 1-5 years (yield 4.33%, duration three years). Here is the price and spread of the latest for the last year:
I’d love to hear from our readers in the bond business if they see value in this part of the curve.
After 60/40 redux
We have leg asking around these parts, what the next 60/40 portfolio should look like – 60% stocks for growth, 40% bonds for stability – if we move into a world of consistently higher inflation. In such a world, the glorious negative correlation of bonds and stocks over the past 30 years or so may be nothing more than a memory.
We affectionately call this replacement the dumb briefcase. It should generate decent returns in the long run, require minimal active oversight, and can’t be overly complex. There should also be enough assets for a wide range of investors. related to inflation I-bonds, for example, have less than $60 billion in circulation. They don’t fit.
Last time we noted that commodities looked better as a hedge against inflation than as a way to raise capital. Some readers have pointed out that we used an index that downplays the performance of commodities by focusing only on raw price performance. They rightly suggested instead trying a total return index, which includes the extra return earned on collateral, usually Treasury bills, that must be held against commodity futures. The difference is noticeable:
However, this is not a high-profile growth story. The latest rally brings us back to the levels of the early 2000s. In the last steady period before that, from the early 1980s to the early 2000s, commodity prices rose 531% compared to over 2,000% for the S&P 500. Expect a trade-off between growth and diversification.
Another possibility is publicly registered infrastructure projects. Tim Robson, terrified of inflation a year ago, wrote that he cut his 35% bond offering to add infrastructure, and liked the results:
This construct has performed, as I had hoped, with significant profits and returns from this infra-distribution, offsetting my capital losses since the beginning of the year.
In the UK, this transition was relatively easy to achieve by purchasing a number of UK-listed infrastructure investment funds.
Some readers have suggested looking at factors such as value or momentum. Here is Caleb Johnson, formerly of AQR and now of Harbor Macro Strategies:
Investors not only need access to more asset classes like commodities, they need access to factor and style premiums. Yes, usually it was available mainly through private investment. . . but they are also available through “liquid alts” in the form of mutual funds and [exchange traded funds] which can be accessed by non-accredited investors.
Consider the style factor of momentum. Commodity ETF treats the entire asset class as a monolith and gives the investor only passive access to it. But a factor-focused fund will do more than offer only long positions, allowing investors to profit from exposure to individual markets by asset class even as they fall in value.
In a similar vein, Philip Seeger of Capital Fund Management wrote that trend following, a close relative of factor investing, looks promising:
Not only is it a diversifier (averaging zero correlation with stocks), but it also has mechanical properties that make it a hedge against protracted, protracted stock moves down (see, for example, the 2008 crisis). We have also recently shown that TF for commodities provides effective hedge against inflation (end-2021 and YTD 2022 demonstrate this). On top of all this, due to its long-term nature and the risk that comes from highly liquid futures contracts, it also scales very well.
We’re not denying the proven power of trend following and factor investing (if done right), but we wonder if the underlying concept might be too complex, even if you can buy it in an ETF. In general, the essence of a stupid portfolio is maximum profitability with minimal trust in your fund manager. Factor investing requires a lot of trust.
Paul O’Brien, a 60/40 optimist, suggested a simpler change:
The key premise of 60/40 is that stocks and bonds are not negatively correlated. This is a low covariance between stocks and bonds. Bonds are less volatile than stocks and will therefore diversify an equity portfolio (lower portfolio volatility) even if the correlation [positive].
Instead of forgoing 60/40, investors may want to hold bonds with shorter duration or [Treasury inflation-protected securities].
Is it possible to build a dumb inflation-proof portfolio as simply as taking a 60/40, adding a few tips and a little investment, and be done with it? (Ethan Wu)
One good read
Fed tightens faster than he thinks?