A dead cat bounce 250 years in the making

1788 was an interesting year. France itched for revolution, King George III was adrift, and New York marked becoming the eleventh US state by hosting America’s first recorded riot, which was over grave-robbing in Manhattan for medical cadavers.

It was also the last time 10-year US Treasuries did as badly as they’re doing now. Chart via Bank of America:

The secular stagnation of the 2010s has given way to secular stagflation. More than one policy rate hike per trading day in 2022, or 243 in total, have set the tone, says BofA strategist Michael Hartnett. The past decade of deflation was on peace, globalisation, fiscal discipline, QE, zero rates, low taxes and inequality. Now there’s war, nationalism, fiscal panic, QT, high rates, high taxes and “inclusion” (his word).

But US treasuries are down two years in a row. The last time that happened was in 1959, shortly after Elvis was drafted. An absence of dead-cat after a greater than 5 per cent annual loss last happened in 1861, the outbreak of the US Civil War, while three consecutive down years has never happened.

Given all that it’s reasonable to expect some improvement. Government bond returns are “almost certain to be positive” next year as the narrative shifts from shock to awe, Hartnett says. The current recession-driven fear of an inflation and rates shock should give way to positive catalysts including peak CPI, peak Fed and peak dollar, which will be “very good for Wall Street if consensus forecasts for ‘hard landing’ in inflation and ‘soft landing’ in growth prove accurate.”

Though sticky inflation and a hard landing for growth look more likely, it’ll still be better than what has just passed, BofA tells clients in its latest Flow Show report.

How to position for these interesting times is a theme taken up by Jonathan Stubbs, analyst at Berenberg, who gives the lamented 60-40 strategy yet another kicking.

The 2022 everything sell-off has broken the relationship between equities and fixed income (both down 20 per cent-ish). We’re headed for the worst year for a traditionally weighted US portfolio since 1937 and the invention of Spam.

In the last 150 years, there have only been four years where both equities and bonds ended the year in negative territory (1941, 1969, 1987 and 1994) – 2022 is on track to be the fifth, and the most extreme.

Since 1872 equity and bond returns have, on a median basis, been negatively correlated during periods of low yields and positively correlated during periods of high yields, Berenberg writes. Equities have historically delivered their worst 12-month forward returns when US 10-year yields have been in the middle range of 3-6 per cent.

So what do do? For the last few years, Berenberg has been championing an all-weather 40/20/15/25 portfolio framework that includes a “liquidity” (?) hedge.

BofA’s more active reversion-to-the-mean analysis suggests going long cash, commodities, volatility, small caps and value. Rising unemployment ought to mean higher defaults and wider credit spreads, so on the way down avoid US stocks, Reits and the dollar.

Also: keep avoiding big tech, which alongside private equity is the “biggest winner of QE-era”.

The falling knives to catch will be long-dated treasuries, junk bonds and emerging-markets securities, since the latter class will be a weak dollar beneficiary, BofA says. Industrials should also work, because the “next policy stimulus will be fiscal not monetary”.

“All great bull markets begin with corporate bonds,” Hartnett tells clients. “Once credit spreads show recession priced-in, we are all-in.”