Stocks and Bonds: Managing Risk and Return Under the Beta Convexity Puzzle
By Vince Foster Sep 30, 2013 10:45 am
Are we on the verge of a deflationary deleveraging cycle or has QE reflated us into an inflationary growth cycle? How this issue reconciles will be a function of which cycle prevails.
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This beta convexity puzzle is not some new paradigm. This is a product of falling real (negative) interest rates. The rising inflation discount lowered real yields, pushing them negative, which raised the net present value of nominal cash flows. This revaluation trickled up the yield curve and down the risk curve. High yield bonds were priced like investment grade credits, and this translated into higher multiples for equity risk regardless of fundamental performance. Multiples have been the principal catalyst behind the rally in risk, and it's occurring in an environment of decelerating growth.
Five-Year Inflation B/E Vs. S&P 500 (INDEXSP:.INX)
This was the Fed's intention and it worked. The problem is that it severely dislocated asset class valuation, and it's not likely this will be without a cost. The Fed believes it can gently raise nominal rates by maintaining high inflation expectations and thus controlling real interest rates. This is why it decided against tapering and why it wants to extend guidance on when it plans to raise Fed funds. Inflation expectations had declined considerably and real yields tightened market conditions.
The market, on the other hand, may have different plans. This is the key to how this plays out. Can the Fed reengineer inflation expectations, or more importantly, convince the market that it is committed to its inflation target? Will the market reflate beta convexity?
How this gets resolved by the market is going to potentially dictate asset performance for the foreseeable future. Thus figuring out how to position for coming out of the other side is going to be the holy grail of asset allocation. Which wing survives the adjustment process? That depends on what dominates the cycle, deflation or inflation, and thus what happens to inflation premiums and real interest rates.
The whole macro debate is whether we are on the verge of a deflationary deleveraging cycle or whether the Fed's QE has successfully reflated us into an inflationary growth cycle. How this beta convexity puzzle reconciles will be a function of which cycle prevails. The convex and concave relationships that have governed beta and asset allocation will return to a linear relationship based on fundamentals.
As interest rates normalize, so too should beta convexity. The first stage of the normalization process was turning the beta convex relative performance into a concave relative performance. The next stage will likely see the emergence of the beta asset that will govern the coming cycle. Was the Fed successful in reflating economic growth that will be bullish for high beta, or will QE have failed to engineer an increase in aggregate demand, thus benefiting low beta? The market is going to answer this question, and I believe it's going to happen over the coming months.
Thus far coming out of the September no-taper decision despite the reflationary bias, inflation expectations have been muted and the performance has leaned towards low beta. Both the S&P 500 and gold (NYSEARCA:GLD) have reversed their initial rally. Bond yields are lower with nominal yields outperforming real yields. It's too early to draw any conclusions and there are a lot of moving parts, however the market has made a significant opening statement.
If the Fed is successful, real yields are going to push nominal yields higher and high beta is going to outperform low beta. If the deleveraging cycle persists and aggregate demand remains subdued, nominal yields will remain low, lowering inflation premiums and low beta is going to outperform high beta. The key metric will be inflation expectations embedded in the yield curve.
No positions in stocks mentioned.