Tactical Asset Allocation – June 2020

RIP Bond Market

The $30 trillion dollar total value of the US equity market is dwarfed by the $40 trillion total value of the US bond market. While the equity market gets more notice, it is the bond market which provides the largest share of financing for government, municipal, and corporate projects.

The fundamental concept behind the bond market is that borrowed money will be used to build private or public infrastructure which will provide a stream of income (or economic growth) sufficient to repay the debt. In short, bond financing has historically been used to boost growth.

Let’s take a quick look at how today’s bond market measures up to its fundamental purposes:

• Corporate issuers have used the largest share of issuance during the past several years to fund stock buybacks. This increases corporate debt levels without increasing the income stream needed to repay the debt.
• Most municipal and state issuers continue to use bonds for public infrastructure which provides long term public benefits. However, increasing numbers are turning to bonds to deal with under-funded pension obligations accruing to past service of employees.
• The Federal government is issuing bonds to fund deficits associated with routine spending which exceeds tax revenues.

In short, the use of the bond market has shifted from providing funds for infrastructure with expected long term benefits to providing funds for current spending with no future benefit. Credit markets have historically put the brakes on this type of spending; however the shift away from prudent, productive use of debt is not the only change in the bond market.

The Fed’s balance sheet held $870 billion in bonds in August 2007 which grew to $2 trillion (7% of the US bond market) by the time the equity market bottomed in April 2009. The Fed’s balance sheet now holds nearly $7 trillion in bonds equal to 16% of the US bond market.

The Fed’s massive moves into the US bond market to maintain historically low interest rates have virtually obliterated the bond market’s risk and price discovery process. How has this happened?

• Historically, the US has enjoyed what the French referred to as “exorbitant privilege”, a process by which the world shipped goods to the US and received US dollars which it then invested in US Treasuries. The world stopped financing the growing US debt in 2014.
• The domestic market was required to take up the slack so the Fed changed the rules under which money market funds and banks operate in order to facilitate increased purchases of Treasuries and GSE mortgages. Most recently, the Fed has permitted banks to leverage their Treasury holdings. But there is still too much supply.
• The rising deficits and Treasury issuance has overwhelmed the capacity of the domestic market to absorb Treasuries absent a significant jump in yields. But neither the economy nor government budgets can afford higher yields.
• So the Fed has become the purchaser of last resort. While the Treasury continues to sell Treasuries to the Primary Broker Dealers, it is the Fed which is actually buying large numbers of those bills and bonds to prevent failed auctions and/or rising yields.
• This is the precursor to “Yield Curve Control”, a concept which has been openly discussed and advocated by Fed officials. Under Yield Curve Control, the Fed dictates Treasury yields along the curve from bills to bonds and buys whatever the market will not absorb at the pegged rates. In short, price discovery of “risk free” interest rates along the timeline from 90 days to 30 years is eliminated. Doesn’t sound possible? The Fed has a prior history in doing this from 1943 until forced to renounce yield curve control in 1951 due to soaring inflation.
• But it goes further. The Fed is extending price controls beyond government bonds by setting up Special Purpose Vehicles to purchase corporate investment grade and junk bonds. The Fed has already purchased $1.6 billion in investment grade and high yield ETFs including LQD, VCIT, VCSH, HYG, JNK. This was done to reverse the widen credit risk spreads as the market began pricing higher default and bankruptcy risks.

For anyone who believes this is all temporary, consider the failed history of Fed attempts to shrink its balance sheet in 2012 (by $100 million) and again in 2018-2019 (by $700 million). In short, the Fed’s balance sheet can not be shrunk because the free market is unwilling or unable to absorb those bonds at artificially low rates.

The end result for investors? While bonds will continue to serve investors as a safe haven during times of financial stress; investors can expect negative real (after inflation) yields on Treasuries for years to come coupled with artificially low rates on corporate debt.

The alternative? Equities and high yield bonds which carry significantly higher risks and volatility.

Bonds Remain Relevant To Our Strategies

Our Tactical Asset Allocation strategies have long relied upon large helpings of bonds, but not for the income they produce. It is the characteristic low volatility of bonds which is key to maintaining high full cycle returns while keeping portfolio volatility tolerable.

Equities (and equity-like high yield) in tight upward trends always command priority portfolio allocation. But when the upward trend of equities (and equity-like high yield) begins to wobble, correct, or decline, risk management algorithms kick in to lower investment risk:

• Adaptive Dynamic Momentum finds tighter trends and higher trend confidence in bonds which boosts the relative priority in selecting bonds over equities.
• Targeted Volatility Weighting lowers portfolio volatility to target levels by shifting allocations from higher to lower volatility investments.

Tactical Adaptive Global provides broad exposure to 16 domestic equity, international equity, commodity, and precious metals funds coupled with 6 fixed income funds used to manage volatility.

Adaptive Income’s basket of 6 funds cover the risk and volatility spectrum from short term Treasuries to high yield. While the 3 high yield funds provide the lion’s share of returns, the 3 government bond funds reduce volatility and provide a safe haven when high yield is under pressure.

Adaptive Innovation’s equity funds carry high levels of both opportunity and volatility. Three government bonds funds are used to dampen volatility both in combination with the equity funds and as a safe haven.

This is why the 3 Tactical Adaptive strategies will continue to lower investment risk while improving returns in spite of the destruction of the bond market.

Perspective

The economy had to be reopened! Just as there are potentially dire consequences from the virus, there are dire consequences from shuttering the economy. By all appearances, there has been a failure in balancing and prioritizing the consequences.

Churchill once commented to the effect that “Americans will always do the right thing after trying everything else”. We are quite likely somewhere along the course of trying everything else but we’ll eventually get to “the right thing”.

Economies thrive on confidence and confidence is waning; in large measure due to the major virus flare ups across the country. The euphoria in the equity market is quite likely at or near an end. We are now likely to see many months, perhaps a year, of hard slogging. The “Fed put” may well hold the lows in place but the market is quite likely to cycle sideways in a 1000+- point S&P 500 range for the foreseeable future.