Mr. Diversification is Bringing Gifts This Holiday Season After a Long Hiatus

December 21, 2018
By Bryce Coward, CFA in Economy, Markets, Portfolio Management

We are quite sure many of our readers are eager to turn the calendar and be done with 2018’s turbulent and unforgiving markets. After all, US stocks have gyrated wildly for the entire year, foreign stocks have gotten absolutely no love, and traditional diversifiers like bonds and gold just added to one’s troubles for most of the year. Indeed, as stocks sold off in February and then again in March, bonds and gold sold off too in an almost conspiratorial way that left a balanced portfolio down just as much, if not more, than an all equity portfolio. It’s a year that has challenged the historical track record of diversification and surely has given asset allocators many a sleepless night. But, just as many had probably written off 2018 as a year in which achieving diversification was impossible, back came Mr. Diversification, just in time for the holidays. In the holiday spirit, we are sure we aren’t alone in giving thanks for Mr. Diversification’s timely return.

Mr. Diversification’s Hiatus

The chart below shows the performance of a wide array of major asset classes from January through October, which happened to be a time when running a diversified portfolio, simply stated, did not work well. Over those first ten months of the year, only US large cap stocks were up on the year, and by a rather meager 1.4%. US small caps were down 1.5%, foreign stocks were down 13%, government bonds were down a whopping 12% and gold was down 7%. Even within the US market, it was a FAANG show and not much else.

Mr. Diversification Comes Home for the Holidays

But by the time the holiday season arrived, back came the benefits of running a diversified portfolio, and right on time. Since November as of 12/20, US large cap stocks are down 9%, small caps are down 12%, foreign stocks are down just 4%, bonds are up 7% and gold is up 4%. That is, foreign stocks have outperformed US large caps by 5%, bonds have outperformed by 16% and gold has 0utperformed by 13%. That is what diversification should look like, where some assets are down, others are down much less, and still others are significantly positive. Welcome home Mr. Diversification!

Is Diversification Here to Stay?

In order to understand whether diversification is home for good or just visiting, it’s important to understand why diversification left in the first place. During the bear market recovery in early 2016 and subsequently through most of 2018, the market’s expectations for inflation were rising sharply. Breakeven inflation expectations as derived from the treasury market rose a full 1%. By early to mid-2018 inflation expectations had risen so far and fast that many market participants were simply throwing in the towel on long-term bonds. They expected inflation expectations to continue rising from 2.25% to 2.5% and beyond, which would have caused the value of long-term bonds to fall precipitously. Instead, reality struck and inflation expectations reverted back to the range that has prevailed over the last five years. Of course, the Fed’s threatening campaign, the rising US dollar and the break down in oil prices all caused the market to reprice future inflation.

Even still, there looms an even bigger force that will tend to put a lid on yields and inflation and put a bid under precious metals: the extraordinary level of economy-wide debt in the United States. When debt levels are as elevated as they are, it doesn’t take much to turn an inflationary boom scenario (that which prevailed into October) into a deflationary bust scenario (that which is unfolding). All it takes is for bond yields to rise a bit too high, thereby putting immense pressure on the interest rate sensitive sectors of the economy. In the chart below, we illustrate the sum of total government debt, state debt, household debt and corporate debt as a percentage of GDP. While down from peak levels, economy wide debt still stands at 5.33x nominal GDP, more than twice the level which prevailed from 1950-1980. This paradigm in general will require the Fed to run looser monetary policy (lower rates and larger balance sheet) for an extended period of time, which generally will cap yields and support precious metals (the insurance against a policy error). So, after Mr. Diversification’s brief hiatus, it does appear that he may be here to stay after all.

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