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This article is inspired by a piece I wrote that was originally shared on my eToro feed in July 2022. Make sure to follow me there as well, and did you know that you can copy my trading there without any extra costs for you? Create an account today, copy my portfolio by searching for user “Allseasonsport” to automatically duplicate my All Seasons Portfolio strategy effortlessly.

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“Is the All Seasons Portfolio strategy not working anymore?”

With an annual drawdown for such portfolios at times almost as bad as for the stock market YTD (S&P 500 currently being down 16% since 1 January, having briefly been below -20%), I am not surprised that I have been hearing this question more and more recently from readers and copiers on eToro.

At the time of writing, my portfolio traded in euros is down about 5% this year (still better than the stock market, mainly thanks to no leverage, more exposure to European bonds which have not declines as much, and positive currency effects), but my eToro portfolio is down 15%, much due to its dollar denomination and the portfolio being levered 1.34x. Such returns were not what I had in mind when we started this year.

Posting such disappointing returns, some soul searching and analysis was due. I wanted to better understand the reason behind these broad drawdowns. The core principle of the Dalio inspired All Seasons Portfolio is that you should always have some asset that is performing, but so far, the absence of the offsetting positive returning asset has been noticeable. For a while, commodities seemed to be the savior, but since early June it was clear that they would not be the ones bringing salvation.

It is particularly challenging when the decline is not isolated to one line item in the portfolio (unless there always is something in your portfolio that you hate, you are not enough diversified), but that seemingly everything is drawing down at once.

An explanation for the poor performance was needed. Is the All Seasons Portfolio – one of the easiest risk parity portfolios for retail investors to implement – really broken, or is there a reason behind the lagging performance? After all, the -5% drawdown of my unlevered portfolio is not that bad actually as it has withstood the declines pretty well. My portfolios are rather well diversified with target allocations as set out below, and having exposure to so many asset classes should have helped, right?

So is the wide drawdowns a bug or a feature?

The issue has not been isolated to the All Seasons Portfolio either. RiskParityChronicles.com tracks the performance of several stable risk parity portfolios (including ASP) on a monthly basis, and the drawdowns are spread across the board. That includes the Golden Butterfly and Qian strategies, as you can see from their June 2022 post.

Knowing that we are in good company in terms of subpar performance is not enough. It is better to understand why.

The first seven months of 2022 can be illustrated by two major themes in terms of financial markets: a) significant underperformance of major asset classes such as stocks and bonds, and b) rising rates.

The latter of these set off an alarm bell for me. Recalling from Alex Shahidi‘s (Co-CIO at Evoke Advisors and manager of risk parity ETFs RPAR and UPAR) books, he discusses interest rate risk as one of two undiversifiable risks that investors and asset allocators face (page 168 of Balanced Asset Allocation and page 145 of Risk Parity).

Alex Shahidi describes unexpected rises in the cash rate as events that will cause balanced diversified portfolios to underperform, as prices fall widely during such environments.

Risky asset classes offer a risk premium above cash. If that were not the case, then no one would rationally investing in that asset class. Why take risk if the expected return is the same or lower than risk-free cash? Thus, all assets effectively compete with cash. The less attractive the yield of cash, the lower the required expected return of asset classes to entice investment. Likewise, as cash rates rise and become more attractive, so should the expected return of risk assets rise (as prices fall) to adequately compensate investors for taking risk.

Alex Shahidi, Risk Parity (2022), p. 145.

With that in mind, perhaps the All Seasons Portfolio strategy is not broken after all? And luckily for us, Alex Shahidi goes on to explain that these events when the (expected future) cash rate rises typically lasts for very short time when the market resets its expectations.

In this post, we will be focusing on how the market has behaved YTD and Last 12 months until end of July 2022, but even if you read this article at a later time, the lessons learned from this period are definitely relevant for portfolio management in general and something to consider also in the future.

Let us therefore take a closer look at whether it is actually rising cash rate expectations that have caused asset prices to fall broadly. I will do so by exploring correlations of each asset class with a proxy for interest rate expectations to see if rising rates has an explanationary power. After all, the year so far has been quite eventful with increasing geopolitical tension (war), supply chain issues, and rising inflation, etc. But let us take a closer look at our analysis below.

Brief macroeconomic backdrop

The common denominator for the themes on the financial markets so far this year (above mentioned falling asset prices and rising rates) is higher than expected inflation. While inflation first became elevated by mid-2021, it was first brushed off as “transitory”, even though this was the belief mainly among central bankers at the Fed.

But, as has become evident over time, inflation turned out to be quite persistent, and with a year over year rate that continued to rise, despite expected to be falling toward mid-2022 due to base effects from the corresponding periods the year before.

High inflation is a wet blanket for companies and thus the stock market in general. Even though some companies can adjust their revenues by hiking pricing at a rate following the inflation rate, they cannot escape that the valuations of the stocks fall in environments of rising inflation. There is a reason why stocks belong in the disinflationary box in the below matrix of asset classes’ biases to economic regimes. The reason for it will be discussed shortly.

But stocks are not the only asset class with such inflationary bias. Also long duration treasury bonds (and corporate bonds) belong in the same camp. Even inflation-linked bonds, which are supposed to fair well during times of rising inflation (see the upper left quadrant) has seen declines so far with the TIP ETF, which tracks American inflation-linked bonds, having lost about 10% YTD.

The reason for this, as I have touched upon in previous posts, is interest rate risk.

What is interest rate risk?

A central bank has a rather limited toolbox at its disposal for carrying out its mandate to maintain key economic indicators at healthy levels, including a stable labor market and keeping inflation in check.

While quantitative easing/tapering is a new such tool where the central bank buys or sells assets from financial markets, the tool which is most associated with a central bank’s activities is the management of its target rate. For the Federal Open Markets Committee (FOMC), this is the Fed’s Funds Rate, and is the interest rate that commercial banks borrow and lend their excess reserves via the Federal Reserve System.

Hence, by adjusting that rate, the Fed can make it more or less expensive for banks to borrow for on-lending to its customers. The effect is that other interest rates in the financial markets will follow the changes in the Fed Funds Rate.

While not directly linked, also the yields of shorter-tenor bonds (30-Day to 2 Year) issued by the US Treasury will closely track the Fed Funds Rate.

This means that the Fed Funds Rate effectively is the cash rate used in asset valuation models such as the Capital Asset Pricing Model (CAPM), Discounted Cash Flow (DCF) models, and Gordon’s Growth Formula use for the risk-free rate on top of which the risk premium is added for determining the required return, and thus the value, of an asset. When rates rise, that will have a negative impact on the value of an asset, as the earned cash flow will have to make up a larger portion of the price paid for the asset.

For example, if equity has a risk premium above cash of 4% when the cash rate is 1%, equities will be priced with a future expected return of 5%. If the cash rate rises to 3%, the expected return of equities will be adjusted to 7%, which causes equity prices to fall.

Consequently, when investing, changes in the cash rate – or rather, changes in the expectations of what the cash rate will be in the future – is a risk that investors will face from time to time. It is important to note that interest rate risk does not necessarily require actual interest rate hikes, but just that the market anticipated rising rates in the future. The first seven months of 2022 has been just such a time.

Interest rate risk is undiversifiable

Interest rate risk does not discriminate. It affects all assets (except commodity futures, for which the returns are not exactly derived from a risk premium), and is therefore difficult to hedge with diversification unless you take a more active approach to trading for example currencies pairs.

When cash rate expectations rise, it is one of the few times when it pays off to hold certain amount of cash in the portfolio, as for example famously promoted in Harry Browne’s Permanent Portfolio (with 25% allocation to cash). Critics to such allocation would of course object that cash loses out to inflation – currently about 9.1% per June 2022 – and that you should does have the money working for you at all time. But then again, losing 9.1% is better than losing a nominal 16% YTD as with stocks without even accounting for inflation.

If the stock market would have been selling off more rapidly and if implied volatility of stocks was to increase when rates rise, VIX exposure could have acted as a mitigant also in a rising rates environment. However, as this has not been the case so far in 2022 with the sell off in stocks being quite orderly, VIX is not a reliable hedge against rising rates just because it has negative correlation with the stock market.

Additionally, there is really no need for the Fed Funds Rate to actually have changed by FOMC for interest rate risk to take hold, as the important factor is the market’s expectations of future changes of the cash rate. If consensus is that rates will rise in the near or intermediate future, it will become more attractive to hold cash relative to risky assets.

Let us know be a bit more practical and look at how interest rate risk has manifested so far in 2022, when the market has (rightly) anticipated rising rates as the Fed (and other central banks) battle persistently higher inflation.

Interest rate risk impact on asset class returns in 2022

In this section, we will be analysing how major asset classes have performed in the first seven months of 2022 and explore whether that performance is at all tied to the market’s expectations of rising rates.

For the asset classes, we will use ETFs as proxies (rather than indicies) to better capture how interest rate risk has affected actual trading.

As for measuring interest rate expectations, we are using the 30-Day Fed Funds Rate futures contract with expiry in December 2022 (ZQZ22.CBT) traded at Chicago Board of Trade. These futures contracts are one of the most widely used tools for hedging short-term interest rate risk, being closely linked with the future course of Fed’s monetary policy (read more about this product on CME’s website).

We are not basing the analysis a constant maturity profile by for example always looking at changes in front month contracts over the analysed period, as we are not interested in how much the rates are expected to change, but only the direction. Because we will be working with correlations, the size of daily movements are not interesting, but only to what extent assets move in the same direction on any day. Hence, while we are looking at correlations for the last year, it is sufficient to use only the December 2022 futures contract, as the price of this contract moves with the market’s changing interest rate expectations. And just to be sure, we have double-checked that the price action of a futures contract with a later settlement date (June 2023, i.e. the contract ZQM23) is similar to that of the December 2022 contract to make sure the analysis presented here below holds up.

As you will find from the below chart, the price of this contract has been trading very closely to par (100) from early 2020 (even being above 100 occasionally in Q2 2020), before a downward trend began in October 2021.

This corresponds with the trend in contracts with other settlement date as well, with the futures were trading around 99.75 until October 7th, when a steady decline began. By 31 Dec, the price was 99.25, declining further to 97.75 by end of Q1’2022, and is currently trading at 96.675 per end of July 2022. As rising rates/yields moves inversely to the price of the asset, rising rate expectations causes the price of the future to decline.

The depicted period also includes several rate hikes from the Fed which have caused greater movements in the price of this futures contract, namely on 16 March (25bps), 4 May (50bps), 15 June (75bps), and 27 July (75bps) to 2.50% in aggregate. Such movements, however, occurred prior to the Fed press conferences in anticipation of rate hikes (in close connection with inflation prints having been published), for example through January and in early April.

This is perhaps seen more clearly from the below chart showing the return YTD of this futures contract, together with its rolling 30-day annualized volatility (right hand side)

Interest Rate Risk versus my All Seasons Portfolio

I started out my analysis for a post on my eToro feed by reviewing the correlation between my portfolio and the ZQZ22 contract. Let us first begin with plotting the lines on a chart, from which we can already see that there is a rather strong correlation in how these two move. Even though the daily moves of my portfolio are more volatile, there is a clear resemblance in the directional moves of the two lines.

Clearly, interest rate risk has been a factor that has been weighing down my portfolio in 2022. With a correlation of 0.920 (R² of 0.844), that implies that the changes in markets expectations of the future cash rate explains 84.4% of the movements of my All Seasons Portfolio.

To put that into perspective, as my portfolio is rather well diversified, the highest correlation that my aggregate portfolio has with any of the ETFs that makes up the portfolio is only 0.32 (with VOO / S&P 500). In other words, changes in interest rate expectations has more explanatory power for my portfolio’s performance than any of the assets held.

Interest Rate Risk versus individual asset classes

We are getting a little bit ahead of ourselves though, so let us take a step back.

Instead of already now jumping straight to the correlation between future Fed Funds Rate expectations and my portfolio, let us dissect its relationship with a variety of asset classes.

Beginning with the ocular analysis. Here below follows a chart of various ETFs, including stocks (S&P 500, Dow Jones, Nasdaq, Total World), long treasuries, TIPS, commodities, gold, real estate and Bitcoin, versus the ZQZ22 futures contract (deep red).

Note that the performance has been scaled to the same volatility as the cash rate futures, as any analysis would have been impossible otherwise (the annualized standard deviation of this contract is about 1.4%). I have also included the six-month correlations against the ZQZ22 contract in the legend to make the chart a bit easier to read.

I find it interesting (there must be people finding also this kind of stuff interesting) how there is a clear relationship between all lines (except for commodities living a life of its own), even though these ETFs in most cases give you exposure to fundamentally different asset classes (except for all stock ETF which all are nuances of the same). Note also how just one single asset class analysed (broad commodities/Bloomberg Commodity Index) has seen returns above zero for the last 12 months, while the rest have suffered various degrees of losses.

While the correlations between all asset classes have been nearing 1 (which you often hear will happen when the poo emoji hits the fan), the underlying explanation is of course that stocks, bonds, real estate – and apparently even Bitcoin – are dependent on the development of the market’s expectations of changes of the cash rate.

Pausing on Bitcoin, I find it rather ironic how this asset, supposedly an asset class that should be decoupled of any relationship with the central banking system as an alternative medium of currency, still has its change in value (relative to the dollar of course) so closely linked with the changes in interest rate expectations. Sure, part of it could be explained by the dollar having strengthened during this rising rate environment, but that this effect is rather small under the circumstances. The euro, for example, has lost 10% against the dollar so for this year (1.1373 to 1.0223), while Bitcoin lost out almost exactly half its value in USD (47k to 23.8k), why the explanation is not only that the dollar has strengthened. I therefore do suggest that another part is explained by that investors expect certain returns on top of the cash rate also in cryptocurrency speculation.

Let us next take a look at a correlation summary of these same asset classes against the Fed Funds Rate December 2022 futures contract over different periods until the last trading day of July 2022.

A couple of reflections on the table:

1. Correlations are impressively high across the board for all time frames except for commodities and gold;
2. Correlations seem to be decreasing lately (3 months column), perhaps as most of the rate hikes for the remainder of the year are already anticipated by markets and thus the ZQZ22 contracts becomes less volatile. As you see from the chart further up that compares ZQZ22 with only my portfolio, this futures contract has been much more stable over the summer than in the first six months of the year, decreasing correlations over this period;
3. The relationship between long treasuries and TIPS broke the last 3 months due to the reason presented in bulled no. 2 above, as the yield of long treasuries also price in long-term inflation expectations, while TIPS exclude inflation and thus more closely follow only changes in the real rate;
4. The stock market is quite dependent on future cash rate expectations, both domestically in the US, but also globally (US stocks making up a majority of global market cap) with rather high correlations in excess of 0.7 even in the last 3 months, with Nasdaq being the sole exception;
5. Gold and commodities, due to their mostly low (and negative) correlation with future cash rate expectations, are good diversifiers in a portfolio, even though they have not been able to offset losses on their own during this particular period;
6. I would have expected real estate to be more closely linked with cash rate expectations (more than stocks in general), considering that this is a highly levered asset class where the main cost of the companies is interest on debt; and
7. R-Squared is very high for all asset classes (save for commodities and gold), implying that the interest rate sensitivity explains a big part of the daily movements of each asset class.
8. Bonus reflection, albeit not reflected in the chart but worth mentioning, is whether the ZQZ22 contract is just another way of expressing the changes in real yield? The correlation between the real 10Y yield and the price of 30-Day Fed Funds Rate futures contract is -0.954, making it an almost perfect fit. These are two factors more or less expressing the same, but I prefer to use the changes in future cash rate expectations as the fundamental driver of both real yields and asset prices.

Hence, there appears to be sufficient evidence that the changes in the market’s future cash rate expectations has indeed impacted the valuations of a wide range of assets. Interest rate sensitivity is a factor to bear in mind for investors, as when cash rate expectations rise, it will drag the major asset classes with it.

Following up on my statement above that correlations between asset classes get closer to 1 when interest rate risk is the main market driver, here below you find a correlation matrix of 6-month correlations to support my claim. Remember, that usually associated with distressed scenarios when everything sells off at once in a panic (sudden and abrupt changes in risk appetite), but is also a feature in a rising rate environment for equities and fixed income. Thus, when rates rise, it doesn’t really matter what risk assets you hold (except gold and commodities).

That also means that the traditional “balanced” 60/40 stock/bonds portfolio has also seen disappointing returns so far this year. Despite bonds’ role as a hedge against recessions (which is likely to follow during the remainder of 2022, if it hasn’t happened already), this is only an asset that offsets losses in stocks when the Fed is likely to drop rates to spur the market (Phil Huber explains this exquisitely in the opening chapters of this book The Allocator’s Edge (2021)). Don’t count on the 60/40 portfolio to rescue you in a rising rate environment, as further diversification is necessary.

And if you are interested in learning how the different assets’ correlations with the 30-Day Fed Funds Rate future has developed over time, here follows a chart depicting the rolling 3-month figures.

Until December 2021 (when the market ever so slightly first began to anticipate coming rate hikes), correlations were effectively non-existent, as the price of that futures contract was barely moving. That also means that interest rate risk has not been a factor for asset values until late Q4 2021. However, on this side of New Years Eve, correlations turned on a dime to become almost 1 – a relationship which turned out to persistent to a larger degree for some assets more than for others – with correlations being again gaining strength from April.

Reading this chart together with table 1 further above, one can start to see correlations again just beginning to come off the highs, but this trend still needs to be confirmed into the coming autumn.

One key element for the cash rate expectations going forward is the Fed communication. Until (and including) the June 2022 meeting, the FOMC has been quite communicative in its intended interest rate path, whereby the market knows what to expect from the Fed in future meetings. From the July 2022 meeting, however, this communication was eliminated, which means that the market now is more blind in what actions to expect from the FOMC in future meetings. Consequently, cash rate expectations (and thus asset valuations) can become more volatile again as this lack of forward looking statements can cause more surprises.

Summary and conclusion

We have reached the final stretch now of this longer article and it is time to summarise and emphasise the key takeaways from the analysis. We will do so in a few bullets here below:

• The beginning of 2022 has seen broad drawdowns in several major asset classes that are typically considered uncorrelated. The S&P 500 has drawn down 16% YTD per end of July 2022, while Dalio inspired All Seasons Portfolios are down somewhere between 5% and 15% depending on leverage ratio and currency exposure.
• The prevailing economic regime for this period has been rising inflation and slowing growth. However, not even inflation biased assets have outperformed in this market regime, where even inflation-linked bonds have suffered. Quite notably, correlations between stocks (US, global, Nasdaq, Dow Jones), bonds, TIPS, real estate and Bitcoin have been nearing 1 over this period.
• With inflation comes rising rates, as the FOMC tries to curb consumer prices. Such rate hikes started in March 2022, but were anticipated by the market from about mid-October 2021 to December 2021. As FOMC appear to hike rates despite a coming recession, assets that hedge against falling growth (treasury bonds) have not added any protection to a portfolio.
• The cash rate – very much based on the Fed Funds Rate – has been rising as rates have been hikes, but it is not the actual rate hikes that are important for asset valuations, but the market’s expectations of what the funds rate will be in the future. During the first six months of 2022, the market’s expectations of what the cash rate will be by the end of 2022 has moved from effectively 0% per late December 2021, to almost 4.00% as of end of July. As the cash rate is used in asset pricing models such as CAPM and DCF models, as well as impacting yields to maturity on bonds, risky assets will suffer.
• Such interest rate risk is one of two undiversifiable risks a long-only investor faces, and this is especially true for retail investors (the other such risk being risk appetite). Luckily, interest rate risk is usually short lived, and once the new rate is priced in and the playing field has been reset, asset price development will again depend on other factors such as changes in expectations of economic growth and inflation.
• We showed how during the first seven months of 2022, most asset classes (except for commodities and gold) have had very high correlations with the 30-Day Fed Funds Rate futures contract with expiry in December 2022 (ZQZ22). The correlations have been between 0.7 and 0.9 over 6 months, meaning that interest rate risk has explained between 60% and 85% of the daily movements in major asset classes during this period, which is an extraordinarily high number.
• Now that the market has priced in rates near 4% by end of 2022, and with even rate cuts being priced in for later expiry dates, interest rate risk should not be as big of a factor from late summer into the autumn.

Therefore, the All Seasons Portfolio (and other well-diversified portfolios) is not broken, but should from now on be performing as usual again now that the expectations of the future cash has to a large extent been adjusted to reflect the new reality.

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You are more than welcome to stick around for this journey that I have been on for several years already with this strategy, and I look forward to interacting with you along the way. And make sure you look up my profile on eToro, if you haven’t already.

All the best,
Nicholas

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The opinions shared in this article are those of the author and do not constitute investment advice in any form. Any mentions of my trading strategy are for descriptive and information purposes only of what I do with my money. All investments carry the risk of capital loss.

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