Here are three things I think I am thinking about this weekend.
1) What’s the best inflation hedge? There’s always a lot of debate about what the best inflation hedge is. Is it gold, commodities, TIPS, stocks, Bitcoin, real assets or something else? It’s not as clear cut as we like to think and the last few years have only added to the confusion. Let’s look at the scorecard:
Bitcoin – it boomed in 2020 well in advance of the big inflation spike in 2021 & 2022 and weirdly busted as inflation reared its ugly head.
Gold & Commodities – They largely did the same thing except they boomed in early 2020 and meandered sideways since.
Stocks – Similar performance as they boomed in 2020 and then meandered sideways for years.
TIPS – Like most bonds, TIPS surged in 2020 & 2021 and then got clobbered when inflation spiked. Weird for an instrument that is called “inflation protection”, but not really that weird given that TIPS have pretty high interest rate risk.
Real estate – Housing boomed in 2020 & 2021 and has moved sideways since. One of the better and more stable performers on the list. Not so true for commercial which has been clobbered.
But the real winner was any fixed rate mortgage locked in by 2020 and before. My friend Jake (he goes by @econompic on Twitter and you’d be wise to follow him) made one of the best calls of the last few years when he predicted this. He beat me out by a few months when I described how I think of this – “A house with a low fixed rate mortgage is a good inflation hedge because you’re long scarce land and short bonds.” 1
So, it turns out that the best inflation hedge of the last few years wasn’t any of the assets we traditionally think of inflation hedges.
2) Where’s the Bond Panic? There has been a lot of chatter about long-term bonds in recent weeks as yields continue to move higher. One question I’ve seen repeatedly is “why is there no panic if bonds are down 50%?” Multiple smart people have asked this exact question. But there seems to be some confusion about this because all bonds are not created equal.
Maybe some of this is a terminological issue since we call long-term government bonds “bonds”, 10 year bonds “notes” and short-term government bonds, “bills”, but for all practical purposes the terms “fixed income” and “bonds” are interchangeable. More specifically, TLT is one of the more widely traded instruments in bond trading circles. It reflects the 20-30 year Treasury Bond and it is indeed down 50% from the all-time highs. So why isn’t there more panic about this? The answer is that this is a fairly small slice of the aggregate bond market and an even smaller slice of most investors’ portfolios.
The total bond market is experiencing a -17% decline from the all-time high. This is significant and unusual, but as I’ve often noted in recent years, bond bear markets are nothing like stock bear markets. Even with as bad as this bond market has been, a -17% decline is a flesh wound compared to what the stock market often does to investors.
But this also highlights a few important points:
A) All bonds are not created equal. The bond aggregate is just an 8.5 year instrument on average. Something like TLT is a 25.5 year instrument. More importantly, just 15% of all government bonds are 30 year bonds while the total US Government Bond market has an average weighted maturity of just 6 years. The long-term sliver of the bond market is a relatively small slice of the broader bond market.
B) Retail investors hold a miniscule amount of long-term bonds. According to the Fed retail investors hold just 9% of outstanding bonds. That would mean that long-term Treasury Bonds are less than 1% of the average retail investor’s assets. Institutions such as banks, insurance companies and governments hold the majority of bonds.
So, why is there no panic over the bond downturn? Well, I guess it depends on who you are. If you’re a retail investor you probably don’t hold that much in long duration bonds to begin with. If you’re a bank you might feel a lot different.
3) The “This is Fine” Economy. I would continue to describe my economic outlook as a “muddle through” view. In other words, I think we’re still digesting the excesses of Covid and that digestion process is still very much in motion. It takes time to digest such a colossal speculative fervor. It’s a good process. It’s not always pretty, but you feel better when it’s done, if you know what I mean.
But as we digest these excesses I can’t help but admit that I have an uneasy feeling about it all. Someone was mocking people on Twitter for predicting that the Fed would break the economy. I’ve said that the risk of the Fed breaking things is high. So I take this personally because that’s the only way to respond to things on Twitter. The main reason I take it personally is because the Fed has broken a whole bunch of stuff and I don’t see how anyone can frame it any other way. For instance, regional banks have been totally broken by the Fed’s interest rate moves. The real estate market, despite experiencing bifurcated price returns, is totally broken from a transactional perspective. And then there’s the bond market which the Fed has thoroughly broken. So, you have the largest non-financial asset market (real estate) and the largest financial asset market (the bond market) and the Fed has broken them both. But I’d actually argue that breaking the regional banks is an even more egregious issue because the whole reason the Fed even exists is because they are designed to support banks. But in the process of trying to achieve a price stability mandate they breached their most important mandate to stabilize banks. It’s all very unsettling and the recent surge in interest rates with mortgage rates moving above 8% makes it all even more unsettling.2
I’ve said that the best way to view this economy is through a bimodal distribution set. That is, muddle through is our base case, but there’s an increasingly high probability that we shift from muddle through to broken down as higher for longer becomes embedded and firms have to roll more and more debt at higher rates. As I joked the other day, it all kind of feels like the “this is fine meme” where the house is burning and we’re all sitting here sipping coffee in the living room pretending like the biggest markets in the world aren’t totally dysfunctional right now. Throw in the Middle East, China and a worsening slowdown in Europe just for fun.
NB – Bear markets are a great time to study up and grind. Downturns create opportunities and while they’re always unsettling they also always end. And the people who come out better in the long-run are the people who grind through the bear markets and don’t give up. For instance, this morning my 2 year old daughter was highlighting her copy of The Handbook of Fixed Income Securities. You gotta start them young, right? So far she’s on track to be either a world champion Mac’N Cheese eater or a financial market guru. Hopefully both.
1 – I am usually critical of high fee long/short strategies, but the beauty of buying a mortgaged home is that despite being one of the most expensive high fee assets you can buy, you also get to drive a bulldozer through it if you’d like. It’s been 4 years since I did that, but the memories are priceless. I am getting the itch to do it again….
2 – I continue to believe that when the dust settles on this era the Fed will be viewed in an unusually harsh manner. The haphazard manner in which they’ve raised, lowered and then raised rates over the course of 4 years is breathtaking. If they cut rates in the coming years because of a panic then I will die of laughter. I will be crying at the same time, but also laughing thru the tears. Anyhow, I will promote automated interest rates until the day I die. Discretion in portfolio management and economic management is necessary to a degree, but if you can automate you should always defer towards removing behavior from the equation and my view is that there is far too much emotion involved in the process of discretionary interest rate management.
Boy, this was long. Are you still here? Go enjoy your weekend. :-)