The perils of investing in the world of one trade

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A banker told me this week that when he meets corporate borrowers and investment clients to discuss what lies ahead in 2024, they always ask him the same question: What are the three big risks? And he always gives them the same answer. One: rates. Two: rates. And three: something horrible that we haven’t thought of yet.

Bearing in mind that item three is inherently impossible to predict or hedge against, this rather crude but also alarmingly accurate assessment means we find ourselves stuck in the world of one trade. 

However tempting it is to join the crowd who believe that corporate earnings or economic fundamentals will reassert themselves as predominant investment themes now that the zero interest rate era is over, US monetary policy and its related impact on bonds remains the most obvious factor for any investor’s performance.

We saw this play out in glorious technicolour last year. As the saying goes, no one rings a bell at the top or the bottom of a trend. But when the government bond market shifted direction last autumn and started to bake in interest rate cuts after a long and painful series of rises, it felt like a big moment even at the time. What is becoming clearer now is the extent to which this switch came to the rescue for fund managers around the world.

For fund managers focused on bonds, this impact makes instinctive sense. “I like to call it the Rip van Winkle effect,” said Jeffrey Sherman, co-chief investment officer at $90bn bond investment house DoubleLine — a recognition that if you had somehow slept through 2023 in its entirety, you would have found that bond yields ended the year almost exactly where they started.

For those unable to sleep that long, however, the turbulent months in between were rather humbling. “It was starting to look pretty painful there in October,” Sherman said. “The last two months [of 2023] made us honest men once again, saying the bonds would do OK. Never confuse the end result with the path you took to get there.”

Similarly, the downturn in the US inflation rate and rapid pullback in bond yields handed a lifeline to heavy-hitting macro hedge funds, many of which tripped up in March when Treasuries rocketed in price as a haven after the demise of Silicon Valley Bank. Riding the huge wave higher in bond prices towards the end of the year helped hedgies to erase those losses and even, in some cases, to end on a high note.

But alarmingly for those looking to diversify returns, whichever big asset class you look at, the pattern is the same. Global stocks, for instance, rose by around 20 per cent last year, as measured by the MSCI World index. But following a pullback in the summer, three-quarters of those gains came in November and December alone, coinciding with the plunge in bond yields. 

Logically enough, the time-honoured tradition of layering boring old bonds on top of a portfolio of stocks also felt the heat. This classic 60/40 portfolio — a mainstay of conservative asset management — is the mullet hairstyle of the investment world. The 40 per cent is the short, sensible business in the front, in the form of a conservative, even dull, layer of bonds with a near-zero chance of default. The party at the back is the rock-and-roll 60 per cent slice in equities that portfolio managers hope will dazzle the crowd. 

In 2022 — the big year for an acceleration in post-pandemic inflation — this divisive look fell seriously out of fashion, as a simultaneous plunge in both bond and equity prices delivered a beating. Investors following the formula in the hope of balancing out safety and fun found themselves hammered from both sides, losing 17 per cent.

Alarmingly, for a time it appeared that 2023 would also prove to be a dud, not on the same scale but a dud nonetheless. Around the middle of the year, equities were doing OK, at least for investors prepared to stick a quarter of their exposure into seven supersized tech stocks, as tracking the S&P 500 benchmark or a broad global measure of shares now, weirdly, demands. But the sickly spell in bonds left a mark. 

Again, though, the turnaround was striking. Calculations by Goldman Sachs show that a theoretical 60/40 mix delivered 17 per cent in returns over the whole of last year — a very respectable run. But some 13 points of that came in the fourth quarter alone. This does not sound like a sensible way for conservative investors to run a stable portfolio and avoid undue volatility.

The negative correlation between stocks and bonds that held true for much of the past quarter century has in effect broken down in the past couple of years, said David Bowers at Absolute Strategy Research. “Bonds are no longer the ‘hedge’ for risk assets that they once were. For a simple balanced fund, life could start to get more volatile as the bond component is no longer offsetting the risk from equities.”

Traders are probably right to assume the Fed will cut rates about six times this year. But it all adds to the pressure on investors to get this call right, rather than messing it up. Again. No pressure. 

katie.martin@ft.com