October 4, 2024
By Steve Blumenthal
“This beautiful deleveraging can only be done in countries that have most of their bad debts denominated in their own currencies and have most of the debtors and creditors as their own citizens, which is the case for China. Doing a deleveraging in this way not only reduces debts without triggering either unacceptable deflation or unacceptable inflation, but it also allows viable businesses to get back to business unencumbered by their old debts and it eliminates the “pushing on a string” problem of having scared people, companies, and other entities holding cash in safe banks and government debt assets. It does this by making cash a poorly performing asset class relative to the major alternative asset classes that are doing well because of the reflation. Doing these things starts to rekindle “bottom fishing” and “animal spirits.” We are clearly seeing that happen now..”
— Ray Dalio, A Beautiful Deleveraging with Chinese Characteristics
Ray Dalio posted an important piece on China this week. Ultimately, China may be the first to initiate what Ray calls “a beautiful deleveraging.” The macroeconomic crises across much of the developed world are debt-related, and attempts to restructure various countries’ debts are in the early innings. The end of the great debt accumulation cycle is the big economic elephant in the room. We need to keep our eyes on it. It won’t be an easy road. Before we discuss Ray’s thoughts on China’s liquidity move further, let’s first look at the risk of recession in the U.S. through the lens of the inverted yield curve as well as what causes lost decades (flat stock and bond market performance).
Inverted Yield Curve
An inverted yield curve is one of those things that sounds complicated, but it’s really just a red flag for the economy, signaling that investors are worried about the future. Usually, when you lend the government money for a longer period of time––say, ten years––you expect to get paid more interest than if you lend money for just a short period, like six months or two years. This makes sense: longer loans = more risk but also more reward.
But when the economic outlook gets worrisome to investors and the yield curve inverts, that more-risk-more-reward logic inverts, too. Short-term bonds become a better, more profitable investment than long-term bonds. When investors are worried about the near future, they’re willing to accept lower returns for long-term investments because they think something bad, like a recession, might be near. Like having a fever signals that you’re sick and your body’s fighting off illness, an inverted yield curve signals that the economy is not well and a recession is likely ahead.
But what defines ahead?
The following chart plots the yield-curve data going back to December 31, 1958. Ten inversion events, excluding the current inversion, have occurred since then. So far, a recession has followed nine of the ten (the exception being 1966-67). Will a recession follow the current inversion? We don’t yet know, but let’s look at the odds.
Focus on the shaded grey lines in the chart. They indicate prior recessions, as defined by the National Bureau of Economic Research (NBER). The small numbers placed before each gray recession bar on the top half of the chart indicate the number of months between the start of the inverted yield curve and the following recession. The shortest intervening period was seven months from the first inversion. The longest was 21 months. It took 11 months before the 2001 recession and 21 months before the 2008-09 recession. The median is 11 months.
It has been 27 months since the start of the most recent inversion, and it’s not over yet.
Inverted yield curves and recessions:
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Inversion happens when the 6-month Treasury Bill yield exceeds the 10-year Treasury Note yield. Many follow the 2-year vs. 10-year Treasury (same idea – when short-term rates are higher than long-term rates, something is not well in the system).
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Historically, inversions have resulted in a recession within 6 to 19 months. Source: Commonwealth Financial Network.
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Among bear markets since 1946, the average stock market decline with a recession was 35.8% versus 27.9% on average without a recession. Source
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Since recessions are only known in hindsight, assessing the probability of a recession in advance is essential.
I’m highlighting it this week, noting the depth and duration of the current inversion. Lights on!
One last and essential point, which is often misunderstood, is that a recession generally begins after the yield curve normalizes (when short-term rates are once again lower than long-term rates). Not before then, but after. That has already happened with the 2-year Treasury yield vs. the 10-year Treasury yield.
Grab a coffee and settle into your favorite chair. I often write about cycles with an eye on risk, of course. Along those lines, I read an excellent post by GMO’s Ben Inker this week examining the popular 60/40 allocation. Looking at the long-term data, it’s easy to conclude that we should all just put 60% in stock indices and 40% in bond indices––just like so many portfolio allocations today. However, Ben noted that six 10-year periods in the last 125 years have resulted in flat to negative annualized returns. The last was from 2000 to 2010. And if you look at those six lost decades, one of two things, or both, were evident before each of them: high equity market valuations or high bond market valuations (low yields). We’ve got both today. This is not a big problem for the 30-year-old, dollar-cost average investor, but it’s an enormous problem for the age 50, 60, 70, and older cohorts. You’ll find an excellent chart from GMO below and a quick summary review of Ray Dalio’s thoughts on China’s liquidity move.
On My Radar:
- 60/40 – Lost Decades Are More Common Than You Think
- Ray Dalio on China’s Liquidity Move
- Random Tweets
- Personal Note: Puerto Rico, NYC, California, and Colorado
See Important Disclosures at the bottom of this page. Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.
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60/40 – Lost Decades Are More Common Than You Think
By Ben Inker, Co-Head of GMO’s Asset Allocation
(Find the complete article HERE)
Asset Allocation Is Easy in Theory, Difficult in Practice
In theory, growing a pool of wealth over decades – whether for a family, an endowment, or a pensioner – is a straightforward endeavor. An advisor or allocator needs to do three things: understand the goals of their client, find different ways to receive compensation for taking risks, and then take the right amount of risk to meet those goals. Taking too much risk may expose the client to unacceptable drawdowns, while taking too little risk will likely lead to inadequate returns in the long run.
The de facto “passive” allocation of 60% equities/40% bonds has proven effective at compounding wealth over time by tapping into two key risk premia: the equity risk premium earned by underwriting the risk of an economic growth shock and an inflation risk premium received for bearing the risk of surprise inflation. Since 1979, when the Bloomberg U.S. Aggregate Index incepted, a 60/40 portfolio made up of U.S. equities and bonds has delivered returns of 10.2% annualized, outpacing inflation by 7.0% and exceeding the return requirements of most investors.
So, we’re done, right? We should all just run 60/40 allocations and call it a day? That approach has worked exceptionally well since 1979, and quite nicely over even longer time periods. While the classic disclaimer on investment ads says past performance is no indication of future results, we can take away some lessons from 120 years of results for a 60/40 portfolio. As Exhibit 1 indicates, a 60/40 portfolio (in this case U.S. stocks and U.S. bonds) has delivered real return of about 4.8% since 1900 – a couple of points less than the 1979-to-present period, but again sufficient for most investors’ needs.
But this enviable long track record hides the fact that there have been six periods, averaging 11 years each, in which an investor in a 60/40 portfolio would have either broken even relative to inflation or, even worse, lost money in real terms. Those chapters share something in common – they all followed exceptionally strong periods of return for the traditional portfolio and thus began when either or both stocks and bonds were trading at extremely high valuations.
Source: GMO
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Ray Dalio on China’s Liquidity Move
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Random Tweets
Tweet 1: “Inflation is a function of federal spending.” Click on the photo to listen to Milton Friedman.
Tweet 2: The FOMC member’s preference for low unemployment suggests that they prefer to cut interest rates too much too quickly to minimize the risk that the unemployment rate moves higher.
Source: Torsten Slok, Apollo Chief Economist
Tweet 3: Fear and Greed Index – Markets on the verge of “greed…”
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to cha
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Personal Note: Puerto Rico, NYC, California, and Colorado
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Stephen B. Blumenthal
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“The blue line in the lower section shows how much the orange line is above or below the long-term trend line. It is currently in the “Overvalued” zone. Lastly, the data boxes at the bottom of the chart display the annualized gains based on each zone (Overvalued, Fairly Valued – blue line in the middle zone, or Undervalued).”Please take note of the following text:
“The blue line in the lower section shows how much the orange line is above or below the long-term trend line. It is currently in the “Overvalued” zone. Lastly, the data boxes at the bottom of the chart display the annualized gains based on each zone (Overvalued, Fairly Valued – blue line in the middle zone, or Undervalued).”