The dangers of investing in the world of one trade

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One banker told me this week that when he meets with corporate borrowers and investment clients to discuss the future in 2024, they always ask the same question: “What are the three big risks?” and he always gives them the same answer. 1: Price. 2: Fees. And he’s third, something horrifying that we haven’t thought of yet.

Bearing in mind that Item 3 is inherently impossible to predict or hedge, this fairly rough but surprisingly accurate assessment means we are stuck in the world of one trade. Masu.

While it’s tempting to join the crowd that believes corporate earnings and economic fundamentals will reaffirm as key investment themes now that the era of zero interest rates is over, U.S. monetary policy and its associated impact on fixed income It remains the most obvious factor to investors. performance.

We saw this unfold in stunning Technicolor last year. As the saying goes, no one rings a bell at the top or bottom of a trend. But when the government bond market reversed course last fall after a long and painful series of gains and began cutting interest rates, it felt like a big moment even then. What is now becoming clear is how much this switch has helped fund managers around the world.

For fund managers focused on fixed income, this effect makes instinctive sense. “I like to call it the Rip Van Winkle effect,” said Jeffrey Sherman, co-chief investment officer at $90 billion bond investment firm DoubleLine. This is the recognition that somehow, if we had stayed dormant all through 2023, we would have found that bond. Yields ended the year roughly the same as they started.

But for those who can’t sleep that long, the intervening tumultuous months were rather humbling. “By October, I was starting to feel a lot of pain,” Sherman said. “The last two months [of 2023] He made us honest again and told us our bond was okay. Never confuse the end result with the path you took to get there. ”

Similarly, falling U.S. inflation and a sharp fall in bond yields have given a lifeline to hard-hit macro hedge funds, many of which sought refuge after the Silicon Valley bank failures as the price of U.S. Treasuries increased. Many of them stumbled during the sharp rise in March. Riding the wave of strong bond price gains toward the end of the year, hedges were able to wipe out losses and, in some cases, even close higher.

But the worrying thing for those looking to diversify their returns is that no matter which big asset class you look at, the pattern is the same. For example, global stocks rose about 20% last year, according to the MSCI World Index. But after a summer pullback, three-quarters of that gain came in just November and December, which coincided with a sharp decline in bond yields.

Logically, the age-old tradition of layering boring old bonds on top of a portfolio of stocks also felt the heat. This classic 60/40 portfolio is a mainstay of conservative wealth management and the mullet of the investment world. 40% is short-term, smart business on the front lines, in the form of conservative, even boring, tiers of bonds with almost zero chance of default. The party in the back is a 60 percent rock’n’roll slice of stock that portfolio managers hope will wow the crowd.

In 2022, a critical year of accelerating post-pandemic inflation, hit by a simultaneous decline in bond and stock prices, this divisive view has become completely obsolete. Investors who followed this formula in hopes of striking a balance between safety and fun found themselves hit by both sides, losing 17%.

Amazingly, at one point it looked as if 2023 would also turn out to be a dud, albeit not on the same scale, but a dud nonetheless. Around the middle of this year, the stock market was doing well. At least for investors who intended to put a quarter of their exposure into seven mega-cap tech stocks, as they are required to track the S&P 500 benchmark and, oddly enough, global stock indexes. . However, the morbid bondage curse left its mark.

However, the turnaround was still remarkable. According to Goldman Sachs’ calculations, the theoretical 60/40 combination returned 17 percent overall last year, a very respectable performance. But about 13 of those points came in the fourth quarter alone. This does not seem like a wise way for conservative investors to run a stable portfolio and avoid excessive volatility.

David Bowers of Absolute Strategy Research said the inverse correlation between stocks and bonds that has existed for most of the past quarter century has effectively broken down in recent years. “Bonds are no longer the ‘hedge’ for risky assets that they once were. For simple balanced funds, life can start to become more volatile as the fixed income component can no longer offset the risk of stocks. .”

Traders are probably right to expect the Fed to cut interest rates about six times this year. But for investors, the pressure is on to get this decision right, not mess it up. Also. There’s no pressure.

katie.martin@ft.com