Jurrien Timmer’s Post

What other portfolio options have the potential to work in this post-Moderation era? In my view, equities of course, plus some bonds, but also hard assets like gold, Bitcoin, and commodities, plus high yield corporates and TIPS. Plus, with bonds no longer providing a port in the storm, there’s a strong case to be made for alts, i.e., uncorrelated assets like managed futures, equity long/short, and absolute return. Today’s diversification is not what most of us are used to. Welcome to the “alt-60/40” era.

If the secular regime has transitioned from the Great Moderation of the past few decades to one of fiscal dominance, perhaps the most seismic change to the investing paradigm that most of us grew up in is the changing influence of bonds in a 60/40 portfolio. During the Great Moderation era (defined as disinflation and low volatility of inflation), the correlation between stocks and bonds was negative. That meant that if there was a shock to the 60 side of the portfolio, the 40 side would offer a counterbalance. You can see in the chart below that the two lines tended to squiggle together from the mid-1960’s to late 1990’s, but have been squiggling in the opposite direction from the late 1990’s until 2022. In the era before the Great Moderation (before the late 1990’s), it was often the 40 side that caused pain on the 60 side. It would be a rise in bond yields that would put pressure on stocks. Bonds were the source of the problem, rather than the answer to the problem. This is how the then-popular Fed model came into existence (which compares the equity P/E to the bond “P/E”, per the chart below). During the “red” phase (positive correlation) the valuation for stocks and bonds moved in lockstep. When bond yields rose too much, the stock market would cry “uncle” and the trend would mean-revert. Then starting in the 2000’s, the model stopped working as deflation fears replaced inflation fears, and bond yields were suppressed by zero interest rate policy (ZIRP) and Quantitative Easing (QE). But since 2022, the old pattern has been back in force, with potentially significant implications for the 60/40 paradigm. You can read more about this in this week’s newsletter: https://lnkd.in/dDY5P8rx

By my calculation (per the discounted cashflow model), the equity risk premium is quite low at 3.5%. It was 5.7% at the October 2022 bottom and 7.8% at the March 2020 low. The historical average is around 5%. I get these numbers by assuming a long-term earnings growth rate of 6% and a payout ratio of 75%. A low risk premium means that the market is more vulnerable to shocks, even if they are temporary.

Now that earnings have inflected higher and rates have returned to more normal levels, the market seems less worried about the reduced number of expected rate cuts than it was a year ago.  The forward curve has already unpriced three rate cuts, but still expects six rate cuts over the next two years. Barring a recession, that seems too many if inflation remains in the 3-4% range. A neutral rate would be closer to 4-5% in that environment. If the forward curve has less downside potential than even now is priced in, it leaves less room for long yields to fall, since the forward curve is a principal driver. My guess is that the 10-year will find a new range in the 4.25-4.75% zone, with risk to 5%. The last time that happened (October), equities didn’t much like it, but today the stock market is on better footing in terms of earnings support. But it’s also more expensive. At a 20.5x forward P/E ratio, the US stock market doesn’t have much margin for error, which means that a sudden negative news event can cause a quick de-risking, as we are seeing now.  

After gaining 28% in a straight line since the last “wobble” (last October), the S&P 500 index is wobbling again and is down 2.4% from its April 1st high. The S&P 500 equal-weighted index is down 3.8% (after gaining 27% since last October), and market breadth has dropped from 85% (of stocks above their 50-day moving average) to 44%. 

Investing requires a non-attached focus on math and probabilities, but at times it’s tempting to just de-risk now and ask questions later. It’s important to have a solid plan that optimizes the intersection of required returns and tolerable risk. From there, it’s a matter of staying the course and rebalancing as needed. In this week’s newsletter we talk about: ❇ The post-pandemic era: the way I see it, the fundamentals right now are of a resilient US economy, sticky inflation, fiscal dominance, monetary restraint, and dollar hegemony ❇ Un-pricing the pivot: now that earnings have inflected higher and rates have returned to more normal levels, the market seems less worried about the reduced number of expected rate cuts than it was a year ago. ❇ The changing influence of bonds: if the secular regime has transitioned from the Great Moderation of the past few decades to one of fiscal dominance, perhaps the most seismic change to the investing paradigm that most of us grew up in is the changing influence of bonds in a 60/40 portfolio. Check it out here:

An observation on the dollar: If the fiscal picture in the US is deteriorating per the new era of fiscal dominance, and gold is rallying sharply as a result, wouldn’t it make sense for the dollar to be declining? That’s what the chart below suggests. Why is the dollar holding up so well? I think the answer is the Fed. While fiscal dominance should be pressuring the dollar, the Fed’s restrictive policy is providing a counterbalance. The chart below shows the US budget balance in purple and the Fed’s policy stance in orange. They are exactly offsetting each other, which is something that doesn’t usually happen. The last time the Fed was getting tighter and the fiscal side was getting looser was the first half of the 1980’s. The combination of a strong economy and high rates is providing an anchor for the dollar. In the chart below, it’s as if the purple line (yields) is holding up the dollar like a marionette. A stable dollar amid rising yields and rising gold prices seems like an unusual combination. But as long as the Fed keeps counterbalancing the liquidity impulse emanating from the fiscal side, I think this can continue. But if the Fed ever capitulates, the dollar may well be the first to go.

A recent development which on the surface might seem unusual is the rally in gold. It has broken out of a multi-year range and is now at $2331. Given that real rates are firmly positive (and historically have been a principal driver for gold’s performance), at first glance this doesn’t make much sense. But perhaps real rates only drive gold during times of monetary dominance, i.e., periods when monetary policy is the dominant driver of asset prices. Perhaps gold responds to different factors during periods of fiscal dominance. Those factors likely include the money supply (monetary inflation), as the gold, money & real rates chart suggests. The monetary base is now growing at 11% despite the Fed’s restrictive stance. Perhaps the Fed is not tight enough, given the liquidity impulse that’s coming from the fiscal side of the ledger? The gold and fiscal dominance chart illustrates that gold is marching to the beat of a different drummer now. The grey dots show a scatter plot of gold vs real rates going back 25 years (weekly data). The purple dots show the post-COVID era of fiscal dominance. The size of the dots shows the amount that the US government spends on debt service.  The negative correlation is gone and gold is now positively correlated to real rates. Positive real rates drive debt service higher, which ultimately elevates the appeal of sound money. That’s what the gold rally is about, in my view. And just because I know you are wondering, below is also the same chart for Bitcoin. 

Several unusual things are happening in the markets, which in my view are most likely explained through the lens of fiscal dominance. We are all painfully aware of the $11 trillion increase in the Federal debt since the pandemic in 2020, and we also know that the Fed has been shrinking its balance sheet (and therefore stopped being the buyer of first or last resort). That has opened a large gap between the issuance of paper and the demand for paper. Yet, the term premium (the risk premium on long-term Treasuries) continues to meander around zero. I could easily see a scenario in which the term premium rises again as the Fed stays out of the market and the Treasury continues to issue more debt. That tells me that a retest of the 5% yield level on the 10-year is a lot more plausible than a return to 4.0% or 3.5%. That doesn’t mean investors shouldn’t own bonds. Far from it. At current levels, Treasuries have 2.8% of downside risk and 11.6% of upside potential if yields were to move up 100 bps or down 100 bps. But in my view, it’s now a coupon clipper’s market.

The incoming data on economic growth continues to indicate that the US may well be transitioning from late cycle back into mid-cycle. We had the jobs report last week Friday, and a few days earlier we had the ISM report (Institute for Supply Management), which now shows the manufacturing sector back in expansion mode. The manufacturing ISM index had been in contraction mode (below 50) since October 2022. Other signs of resilience come from the consumer side. The bank deposits chart below shows that bank deposits are on the rise again, after contracting in the wake of the mini banking crisis 13 months ago. And bank reserves continue to hold steady at around $3.4 trillion, despite the now $1.5 trillion reduction in the Fed’s balance sheet. The roundtrip in “excess liquidity” (the difference between money growth and economic growth), is almost complete, from a 30% positive excess in 2020 to a 12% negative excess in 2022.