It is difficult to build a case that equity markets won’t contract in a slow-down. Since 1950, whenever CAPE valuations were above 20 and industrial production declined in the previous 12 months, the 12-month return of the stock market was -10.4%, with only 34% of periods having positive returns.
Interest income is attributable for all or most of bonds’ downside protection; therefore starting yields are critical. Bonds have traditionally been an important component of any portfolio derisking strategy but interest income has been a significantly larger piece of the return pie during economic downturns; whilst spread compression has been less significant.
Our analysis suggests that:
1. Low volatility strategies outperformed among publicly traded equities
2. Exposure to corporate default risk reduced bonds’ downside protection.
The three preconditions that led to the stagflation period of the 1970s are less likely today. But the relationship between trade disruptions and growth could catalyze a global recession and the relationship between oil prices and inflation expectations could abort the easy monetary policy which current asset prices discount.
Our evaluation of key downturns over the last 30-year point to 3 key differences between today’s macro backdrop and the most recent period.
As a backdrop to our portfolio derisking recommendations, we evaluate the macro background, asset return sensitivities and market responses during economic downturns over the last 30 years.