Ah, late Summer, when you start feeling sad that the warm and sunny carefree days are close to an end, the evenings spent on the back patio will soon require a fire and a sweater, and you turn your attention to Fall. But before you can truly start growing that seasonal beard in earnest, there’s the Federal Reserve’s annual meeting in Jackson Hole to bring you one last bright burst of Summer happiness.
Normally this is a rather boring affair, full of policy speeches and wonky economics. This year, while it was still full of policy speeches and wonky economics, there was an interesting twist when Jerome Powell presented his speech with the titillating title of New Economic Challenges and the Fed’s Monetary Policy Review.
The seismic shift that Powell laid out in his speech is that they are no longer going to try to put the brakes on inflation before it hits their 2 percent inflation target but are going to target an average inflation rate of 2 percent over a particular, yet undefined, time period. The past three decades of Federal Reserve chairmen have kept the runaway inflation of the 1970s firmly in mind when setting monetary policy and they’ve sought to stop inflation before it gets overheated. However, as the last three decades of inflation has shown us, and especially the last two decades, runaway inflation in the face of massive Federal Reserve stimulus and full employment has not created the nightmare debasement of the currency that so many inflationistas have warned us about.
They also seemed to re-prioritize full employment over short-term inflation, but that’s not germaine to this discussion.
The reason this speech was so eye-opening was that it finally confirmed that the Fed is likely to set interest rates lower for longer. To be blunt, the Fed is looking to generate some inflation and they’re willing to keep interest rates below inflation to make it happen.
The problem with this approach for investors is that “risk-free” Treasury notes no longer provide a positive real return. Everyone will have to look elsewhere for an asset that is negatively correlated with equities and can dampen volatility while still providing a positive real return.
I can’t remember who was writing about this seeming anomaly years ago, but their question was why it was possible for an asset that acted like an insurance policy in times of market stress to pay the investor for the insurance. For any other insurance policy it is the investor paying the insurer. While whoever that writer was probably isn’t surprised by this turn of events, the rest of the world will have to review their options.
Positive Returns & Minimal Drawdowns
There are not that many alternatives that are likely to be as reliable and steady a performer as Treasury bonds were when it comes to portfolio construction. An investor these days now has several options, none of them great:
- 75/25 is the new 60/40. There have been some articles going around arguing for a higher equity allocation and a lower bond allocation. This will likely lead to higher returns but the increase in volatility, especially given how market-weighted equity indices are valued, is going to make it harder for investors to stay the course during the next pandemic, climate change, or sharknado (hey – 2020 has taught us anything can happen) -induced recession. This also ignores the fact that equities can go down substantially and stay down for far longer than anyone expects.
- Trendfollowing. Investors could take a portion of their bond allocation and either invest in a managed futures fund or take a DIY approach to a trendfollowing strategy. There’s always a bull market somewhere and a trend filter will keep investors from losing all their capital, but returns are not guaranteed because markets can always go sideways and chop up any trend strategy out there.
- Short-term trading. This probably comes with the warning label of “For professionals only, don’t try at home,” but with the democratization of online trading there are oodles of investors that have decided to try their hand at it. For most people it won’t work – it’s like trying to be a professional poker player. There will be a handful that can make money with a short-term trading strategy but most will lose money.
- Long-Short equity. Most industry observers argue that the financial markets are getting more competitive and the easy alpha is long-gone, but if you view this as a bond replacement instead of comparing it to long equities in the same time period, then 2.8 percent annualized returns is much more attractive than most bond alternatives.
- Save more money. While this approach isn’t possible for retired people or an unfortunately large number of people in the middle and lower income brackets, saving more money is the safest and surest way to accumulate more assets
I think the days of a simple 60/40 allocation or even something fancier like the All Weather Portfolio generating meaningful real returns are probably behind us for at least the next decade.
Whether All Weather will Weather
If you take the gold-standard for solid returns and comparatively minimal drawdowns and decompose the sources of returns going forward, you’ll realize that simple portfolios are in trouble. With 20-year yields at 1.15 percent, IEF at 0.36 percent, the SPY’s CAPE at 32x (lower if you invest on a global equity basis), gold close to all-time highs, and the most accessible commodity indices still containing 30+ percent energy exposure, there’s not a lot of sources of incremental returns available. The All Weather portfolio, and any other similarly constructed portfolio, may preserve your assets but they’re all much more likely to deliver anemic returns no matter what happens next.