The new-old regime

Equity risk premium, the correlation between stocks and bonds and the impact on the asset allocation framework.

Even if it seems linked to a period very distant from today, the positive correlation between bonds and stocks is not something entirely new. Before the 2000s (years characterized by much higher inflation than we are used to now and above all much more volatile), in fact, having movements of the same sign between bonds and shares was not unusual. At the same time, it was also not strange to see interest rates being higher than the returns offered by stocks.

Taking inspiration from one of my favorite morning reads (John Authers' Columns) written by John Authers, at Bloomberg editors, I thought I'd link to a graph that he showed in order to talk a little about the different market regimes we are witnessing and the impacts that the latter have had and could have on asset allocation.

John presented the chart above commenting “Comparing the dividend yield of the S&P 500 with the two-year Treasury yield, there has been a sudden return to the old status quo, in which short-term bonds yielded more than stocks. As the government must offer an attractive rate to fund its deficits, this is unlikely to change for a while. The TINA (There Is No Alternative) support that low bond yields offered share valuations for a decade after the Global Financial Crisis is now what Ian Harnett of Absolute Strategy Research in London dubs TINY — There Is No Yield on stocks: 

Taking a less crude measure, back in the 1990s people used the so-called “Fed Model,” because the central bank’s chairman Alan Greenspan appeared to rely on it in congressional testimony. This held that higher yields on bonds would require a higher earnings yield (the inverse of the price/equity multiple) from stocks.”

So to sum up the concept, we passed the last 20 years in what Albert Edwards (a SG economist and strategist) call a Ice Age, characterized by low inflation and fear of deflation. But what led to this regime change? Probably one of the most universally recognized causes was (along with the forces of globalization which has shrunk the world and reduced costs) the crisis of the Asian markets between '97 and '98.

Asian Financial Crisis of 1997-98 was a domino effect that wreaked havoc on East and Southeast Asia's economies. It started in July 1997 with Thailand that devalued the bath (thei currency) on speculation of unsustainable foreign debt, and with a domino effect it weakened (with a wave of sell) all emerging market currencies. The devaluation wave created a wave of default too, stock market crack, capital flight and (after a period of inflation spike) a crash in demand. Low confidence and low growth subsequently led to an increase in unemployment rates and therefore to deflation.

Deflation, a monster that is difficult to get rid of, as we have been able to learn from the 90s in Japan and in developed countries over the last 20 years.

So returning on the market and on the bond yield offering an yield above what offered by the equity market (first panel of the chart below), we can calculate an ERP (equity risk premium, in green in the bottom panel) as:

ERP = Earning yield - 10y UST yield

In some of the morning comment written by Mohit Kumar (a strategist at Jefferies) he suggested a link between ERP and the correlation between bonds and equity and how with a negative ERP the correlation between yield and equity can switch and become negative (read in another way equity and bonds move together, with a positive bond/stocks correlation). I tried in bloomerg to create this and above in purple what I obtained. Yes, the ERP is now negative and the correlation is now negative (positive that one between bond/stocks). This has important consequences for market, in fact, if rates increase further, this will have negative impact of bond clearly, but also with equity.

Now again a little bit of history, between the years 2000 and 2020, the negative equity/bond correlation gave rise to a whole series of risk parity, 60/40, etc. strategies, with the idea that the volatility of an asset class can be absorbed by the earnings of the other (All weathers portfolio for example). These strategies have been destroyed by the rise of post-war inflation in Ukraine and the return of inflation (a phenomenon we were not used to) but it is a return to a new-old regime.

With an increasingly multipolar world and increasingly frequent nearshoring and protectionist strategies, a higher level of inflation is to be expected, in fact, in the coming years. This will continue to put pressure on the strategies we have used in recent years (60/40 long only) and will probably require the inclusion of raw materials and commodities in a more structural way, to diversify, first and foremost, but to protect from inflation spikes that could be increasingly frequent.

As I said several times: "Energy independence + food independence = social stability"

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