SocGen: “Asset Markets Have An Inescapable Problem”

Highlighting something we discussed over the weekend, namely the rising, and now positive correlation between bonds and stocks…

… SocGen’s Andrew Lapthorne writes overnight that as equity market investors digest some unfamiliar volatility, what will be concerning asset allocators is the now positive correlation between bonds and equities as bond yields rise. “Or put simply, it is becoming very hard to avoid losing money.”

As an example, Lapthorne points out that as equity markets fell last week (MSCI World -3.4%) due to rising bond yields, pretty much every other asset lost money as well.

This harks back to the 2008 period when the New York Times – among many others – wrote about the failure of diversification leading to much head scratching and ultimately helped spawn the alternative risk-premia industry. Given the shorter duration and relatively limited downside risk of bonds relative to equities, if the sell-off persists we expect increasing pressure to take money out of equities and rotate into bonds”, Lapthrone adds.

This observation leads Lapthrone to note that “asset markets have an inescapable problem, i.e., historically low level nominal yields on a global balanced portfolio and depressed real yields at a time of low inflation.”

To get higher real yields from here, either inflation needs to head even lower (risking deflation), or yields rise due to falling prices. Neither outcome is very positive.

And another thing worth noting: normalcy appears to be slowly returning to the market, with losses for companies boasting the worst balance sheets double those with the best:

In down markets, balance sheet risk is always the most  important factor, and this bout of equity market weakness is proving no exception. Our equal-weighted index of US companies with the worst balance sheets was down 6% last week vs a 3% drop for those with the best.

And visually:

So is this the end of the bull market, especially for the most heavily levered companies? For now the answer is unclear:

“We never know if a sell-off is part of a longer-term trend as this can only be judged ex-post, but we don’t think managing an orderly decline in asset prices and the associated rise in volatility at a time of record valuations and high corporate leverage is going to be a ’healthy exercise’.”

Then again, judging by the sharp rebound in risk this morning which was kicked roughly when the White House said that it is getting “concerned” about the selloff, we may have to shelve predictions about the end of the bull market for another day yet again…

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