What Did We Learn This Week? (10/20/2022)–60/40

60/40

Writing about the shortcomings of 60/40 when the strategy has had its worst drawdown in many years has the feeling of closing the gate after the horse is already out of the barn and through the pasture. That said, we have two long-term concerns that inform our view that greater diversification and a more defensive allocation is warranted, at least for those of us who have celebrated our fiftieth birthdays. First, as anyone who has followed our work knows, we believe that inflationary pressures are secular and will therefore provide an enduring headwind against rates falling and equity market valuations rising. The second reason is tail risks and two specifically stand out to us. One is the growing risk of a China less focused on growing its economy via global economic integration and more focused on regional domination. Second is the concern that after forty years of falling inflation and generally growing global cooperation, we should have some damn humility about our ability to have any idea what the world will look like as both of those trends have reversed.

Blackrock’s Jeffrey Rosenberg recently wrote, “The inflationary outlook is the number one issue, and as long as that inflationary outlook remains unclear, we're going to have an environment where stock markets and bond markets have the potential to move down together.” In other words, bonds don’t work as a hedge for stocks when stocks are going down because of inflation concerns.

In the near-term, inflation is absolutely going to come down cyclically. This Fed has made that a certainty. Commodities, freight, used cars and even housing/OER is finally slowing on an annual rate of change basis and on an absolute basis when we look at sequential month over month data. We are going into a recession and in every recession demand declines and drags inflation with it. The only question is how fast will inflation fall given the continued resiliency of consumer spending and nominal growth. I can’t answer that question other than to reiterate the famous Milton Friedman truism that “monetary policy works with long and variable lags”. The more important issue to understand for financial advisors and any fiduciary is what happens to inflation over the next decade, not just the current cycle.

To those who believe that inflation will be an ephemeral and cyclical phenomenon, I have two questions: From where will the workforce growth come and from where will the cheap oil come? Ultimately, the only way to overcome our worker shortage and our chronic energy underinvestment is an inflection from productivity and innovation. I’m sure both will come eventually, but when, as of now, is unknowable.

As for the tail risk in Taiwan, I don’t have any other insight other than what we can all read in the newspapers. But, given the global reliance on Taiwanese semiconductor manufacturing to make everything from toasters to automobiles, there is no indication that any escalation is priced into markets currently despite saber rattling comments from Xi last week.

Xi, amid his coronation week, was quoted as saying, “Taiwan is China’s Taiwan…Resolving the Taiwan question is a matter for the Chinese, a matter that must be resolved by the Chinese. We will continue to strive for peaceful reunification with the greatest sincerity and the utmost effort, but we will never promise to renounce the use of force, and we reserve the option of taking all measures necessary.” In response, the US Secretary of State Anthony Blinken doesn’t seem to think Xi is bluffing. This week, he said in an interview with Bloomberg, “What’s changed is this -- a decision by the government in Beijing that that status quo was no longer acceptable, that they wanted to speed up the process by which they would pursue reunification. They also, I think, made decisions about how they would do that, including exerting more pressure on Taiwan, coercion -- making life difficult in a variety of ways on Taiwan in the hopes that that would speed reunification.”

The precedent of the last forty years of falling inflation can be thrown out the window because we are in uncharted waters of modern financial history. The current aging demographics are unprecedented, as are the current soaring debt to GDP ratios, as is deglobalization. The Fed has shifted radically from historical levels of accommodation/money-printing to a historically rapid tightening cycle in less than a year. Volatility has surged in equities, bonds and currencies. The risk of blowups in sovereign bond markets rises with each passing day. Until a month ago, very few of us had ever heard of “Liability-Driven Investments” and yet those strategies brought enough turmoil in UK and global financial markets to lead to the ouster of a brand new British Prime Minister. We never know the future, but at least we usually have some historical precedent to see the risk parameters. That unfortunately is not currently the case today.

The prescription is simple: when volatility rises, incur less risk. The good news is that we finally live in a world where one can achieve mid to high single digit appreciation or even higher while taking minimal risk. In this case, discretion is the better part of valor. Be smart. Be patient. Hit singles until a better opportunity avails itself.

For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

Tim Pierotti is WealthVest’s Chief Investment Strategist. 

Tim has over 25 years of experience in various aspects of the equities business. Prior to joining WealthVest, Mr. Pierotti spent seven years in Equity Research management roles at Deutsche Bank and most recently at BMO where he was a Managing Director and Head of US Product Management. Tim has 11 years of investment experience most notably as Head of Consumer Research and Portfolio Manager at The Galleon Group, a former NY based $8Bln Long/Short hedge fund. Tim is a graduate of Boston College and lives in Summit NJ.

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