August 13, 2023 – The highly anticipated film “Spider-Man: No Way Home” was released to much fanfare in December 2021. The movie became the most financially successful film of 2021, grossing a whopping $1.92 billion globally.
What made “Spider-Man: No Way Home” unique was its incorporation of the concept of the multiverse. The film brought together various iterations of Spider-Man from different universes, including appearances by actors from previous Spider-Man film adaptations. This concept of a multiverse allowed for a nostalgic and unique crossover experience that excited fans and garnered significant attention both within the pop culture sphere and in the broader media landscape.
At the risk of stretching the financial analogy a tad far, perhaps the diversification across universes was one of the reasons for the resounding success of No Way Home.
While they did not know it at the time, 2021’s vintage of U.S. Treasury bond investors were about to discover that there would be no way home for them come 2022 and onward.
Twenty months ago, the 30-year U.S. Treasury was yielding a paltry 1.9% while the inflation rate was surging. In December 2021, the U.S. inflation rate jumped above 7.0% for the first time since 1982.
Buying long-duration bonds yielding below 2.0%, while inflation exceeded 7.0%, seemed to be about as smart as the Green Goblin fighting three Spidermans at once (hint: it did not go well for the villain).
What were long-term Treasury bond investors thinking at the time?
I distinctly remember a discussion with an allocator from that period.
“Why own long-term Treasury bonds when real yields are so deeply negative?”, I asked.
“Those long-term bonds are there to protect our stock portfolio in the next equity bear market,” they replied.
We all know how the story went. Stocks got smoked in 2022, sliding into a bear market as the Fed rapidly tightened monetary policy to combat persistent inflation.
As interest rates continued to leap higher, bonds followed stocks, dropping precipitously and producing double-digit losses.
Long-term bond allocators found themselves in a web of trouble as Treasury bonds tracked tech stocks nearly tick for tick. Both assets suffered a painful thumping in 2022.
Mistakes were made, and those owning Government bonds soon came to regret it
While bonds did provide a diversification benefit for declining stock portfolios in three of the most recent four equity bear markets, throughout the majority of history, bonds have been positively correlated with stocks and therefore provided very little by way of diversification.
If 2022 did not teach allocators the lesson, studying history is worthwhile. Throughout most of the past 80 years, stocks and bonds have been positively correlated, meaning more often than not, they have moved in tandem.
Historically, bonds have served as a poor hedge for stock portfolios.
The concept of positive stock and bond correlation is theoretically sound. The so-called Fed Model stipulates that investors should compare the potential returns from stocks with those from bonds. Suppose the potential return from stocks (as indicated by the earnings yield) is greater than the return from bonds (as indicated by the yield-to-maturity), then stocks may be perceived as offering a better value. As bond yields rise and discount rates increase, the intrinsic value (as determined by their discounted cash flows) of both stocks and bonds fall.
Higher interest rates should mean lower prices for stocks and bonds, meaning their values should be positively correlated on average.
It was a breath of fresh air to hear capital allocator and Pershing Square CEO Bill Ackman recently announce that his firm is short 30-year U.S. Government bonds as a hedge against their equity book. This position is the opposite of what most other allocators have done over the past 25 years.
He tweeted (X’ed?), “I have been surprised how low US long-term rates have remained in light of structural changes that are likely to lead to higher levels of long-term inflation including de-globalization, higher defense costs, the energy transition, growing entitlements, and the greater bargaining power of workers. As a result, I would be very surprised if we don’t find ourselves in a world with persistent ~3% inflation.”
“So if long-term inflation is 3% instead of 2% and history holds, then we could see the 30-year T yield = 3% + 0.5% (the real rate) + 2% (term premium) or 5.5%, and it can happen soon. There are many times in history where the bond market reprices the long end of the curve in a matter of weeks, and this seems like one of those times. That’s why we are short in size the 30-year T — first as a hedge on the impact of higher LT rates on stocks, and second because we believe it is a high probability standalone bet. There are few macro investments that still offer reasonably probable asymmetric payoffs and this is one of them.”
His math makes sense. Historically, the 30-year yield has traded more than 100bps higher than the fed funds rate on average. In addition, the Fed funds rate has historically been 160bps higher than inflation. Therefore, the current 30-year U.S. Treasury bond yield of 4.2% implies a long-term inflation rate of approximately 1.6%.
While the rate of inflation has declined from its 9.0% peak last summer, a steady decline and stable landing at the targeted 2.0% level is no easy feat. Arguably, the current market prices of U.S. equities, with a 5% earnings yield, and long-term U.S. Government bonds, with a 4.2% yield-to-maturity, may be pricing in this rosy scenario.
A reacceleration of inflation, or even persistent inflation of around 3.0%, would be challenging for bond investors. In addition, it could be the stuff of the Fed’s nightmares. Reaccelerating inflation should be in the realm of possibilities, as it has happened before.
Numerous risks are emerging in the economy that could spark a rise in inflation or at least halt its recent decline at levels higher than bond investors are pricing in.
First, oil prices have been rising, recently hitting year-to-date highs. Geopolitical turmoil, the war in Ukraine, and Saudi Arabia’s eagerness for production cuts have caused tight oil supplies, leading to elevated prices. A sustained rally in energy prices would catch many CPI basket components in its web of inflationary forces.
Second, wage inflation has recently begun to reaccelerate.
In a headline-grabbing triumph, the UPS union secured an annual salary increase for its average delivery driver to a stunning US$170,000.
At US$170,000 (C$228,000), a UPS driver would be in the top 2% of income earners in Canada, collecting well over 5x the country’s median income of $41,200. The average UPS driver will out-earn the median doctor’s income of C$217,000. It is highly likely that other unions have noticed this stunning wage increase, and may take it into account during their next round of labour negotiations. Wages appear to be heading much higher, potentially keeping the inflation rate elevated and interest rates higher for longer.
In addition to the underlying fundamentals affecting inflation and interest rates, bond investors also increasingly face headline risk.
Last week, Fitch Ratings downgraded its rating on U.S. debt from the highest AAA rating to AA+, citing “a steady deterioration in standards of governance.”
Explaining its rationale for the downgrade in rating, Fitch outlined “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”
Fitch is not the only debt rating agency that has downgraded U.S. government bonds. S&P downgraded the United States’ credit rating in 2011.
While not the be-all and end-all (debt investors must do their own credit research), another downgrade from AAA adds to the headwinds facing long-term U.S. Treasury bonds.
To summarize, given the myriad of risks confronting bond investors, including stretched valuations (unjustifiably low yields), positive correlation to stocks, upside inflation risk, and headline downgrade risk, things are not looking favourable for investors allocating to long-term Government bonds.
Allocators must take heed from our friendly neighbourhood Spider-Man – with great power comes great responsibility. Allocators should use their power and reduce their long-term bond allocations to diversify into several alternative asset classes that can do well in a high interest rate environment.
Accelerate manages four alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): Cash Plus
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Portfolio Protector
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Portfolio Stabilizer
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50
ARB declined -0.1% for the month and gained 1.9% year-to-date, compared to a 0.6% monthly increase and -0.6% year-to-date decline for its benchmark S&P Merger Arbitrage Index.
The primary cause for the monthly underperformance was the Fund’s lack of exposure to the Black Knight / Intercontinental merger arbitrage. This deal was initially announced in May 2022 and caused significant consternation for arbitrageurs. The merger caught the ire of antitrust regulators, leading to substantial delays, ultimately resulting in divestitures and the deal repricing down -11.8%, from $85.00 to $75.00 per Black Knight share. While dodging the initial carnage and losses proved wise, we warmed up to the deal once divestitures came to fruition this summer. However, although we turned positive, we did not move quickly enough to establish a position in Black Knight, which was an error of omission as the stock rallied this month with the deal now set to close shortly.
In any event, the Fund remained active in July, investing in five new merger arbitrage deals (out of fourteen announced). Three SPAC IPOs were added (out of four to hit the market). Currently, the Fund is allocated 58.9% to SPAC arbitrage and 41.1% to merger arbitrage, with total gross exposure of 153.3%.
HDGE eked out a 1.6% gain in a somewhat difficult month in a challenging year for long-short, absolute return strategies. Most U.S. long-short factor portfolios suffered losses in July, with the price momentum and trend portfolios taking the worst of it, dropping -8.9% and -10.2%, respectively. Long-short value was the only market-neutral U.S. factor portfolio with positive performance, gaining 3.7%.
There has been a significant rally in low-quality junk stocks, with the Goldman Sachs most shorted index surging 17.0% in July and 40.3% year-to-date. Given this challenging hedging environment, some of the Fund’s peers have suffered double-digit losses in 2023.
For those running short portfolios, risk management has been paramount. The Fund’s portfolio management team runs a strict, systematic risk management framework, both in portfolio structuring and daily monitoring. For example, when rebalancing the portfolio, the Fund does not short stocks with short interest above 20.0% and does not short stocks with borrow cost above 5.0%. Staying away from heavily shorted names reduces short squeeze risk. In addition, the portfolio management team manages individual security and net portfolio short exposure daily, dialing back positions and exposure should it rise above pre-set thresholds. Also, the Fund’s factor and geographic diversification, along with its beta-neutrality, have allowed it to outperform its peers thus far in 2023.
ONEC gained 1.0% in July, with most alternative asset classes generating modest positive performance.
The inflation protection allocation led the Fund’s positive return for the month, with gold rallying 3.0% and commodities increasing by 1.6%. Enhanced equity was the Fund’s other top gainer, contributing with a 2.9% return.
ONEC’s allocation to real assets also contributed positively, with real estate jumping 2.5% and infrastructure up 1.0%.
The absolute return allocation generated a 1.6% return for the month, while arbitrage was flat. Private credit, consisting of mortgage and leveraged loan portfolios, was up modestly, while the global macro allocations, including risk parity and managed futures, combined for a slightly positive contribution.
ATSX gained 2.9% for the month, while its benchmark, the TSX 60, was up 2.1%.
The Fund’s 50/50 long-short overlay portfolio contributed 80bps of alpha in a mixed month for Canadian factor portfolios.
In contrast to the U.S. equity market, the Canadian market had less of a speculative junk stock surge in July.
While the Canadian multifactor portfolio generated positive alpha, its underlying factors had mixed results. For example, the value and quality long-short portfolios gained 5.4% and 3.6%, respectively, while the price momentum and trend long-short portfolios lost -3.5% and -4.1%.
In July, fundamentals worked while technicals did not.
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.