Contents of this month’s post include:
- Market Update of the current economic regime
- Monthly Portfolio Update for August 2022 with a fresh set of charts
July is well behind us, and now that most of the rate hikes in the US up to about 3.75-4.00% are expected and priced in, the All Seasons Portfolio got a bit of a revenge this past month with some positive performance.
Speaking of interest rates, in case you missed it, I recently published a longer Insights article about interest rate risk, and specifically how it broadly affects most asset classes (correlations go to one) and how that macroeconomic factor explains changes in asset prices during the first half of 2022. This is a valuable lesson to bear in mind also in the future (if you are reading this article later). Check it out via the link above when you find the time!
Let us continue with taking a closer look at how this all affects the markets and the macroeconomic regime we are currently in.
August 2022 Market Update
First, the usual reminder regarding the All Seasons four-square matrix of macro factors, as more or less all market moves can be traced back to essentially two forces: inflation and economic growth, and especially positive and negative changes in expectations of these.
That gives rise to four possible market regimes, as a combination of the two factors can be summarized by a matrix of four squares with inflation and economic growth on on axis each. The four possible regimes are this inflationary stagnation, inflationary boom, deflationary bust, and disinflationary boom.
This will serve as a backdrop for for the below summary of what market regime we are currently in, which might help us explain changes in asset prices.
In what market regime are we now? The US inflation rate for July was just published as 8.5%, down from 9.1% in June, and below market expectations of 8.7%. It could be that inflation has peaked, as theorised by several market commentators and macro traders, and that the main fear on a forward-looking basis is weak growth. This would again decrease the correlation between stocks and bonds, which has been rather high during the first six months of this year.
The below charts only show the July numbers (the latest month when we have had data available for both inflation AND economic growth), and thus do not show this just yet.
The general trend we can begin to see in this chart is that inflation (green lines) appears to have peaked in the summer and is starting to come down, and that 5Y inflation expectations have come down the April top, even though it again rose gently in August.
As for growth, this is still in negative territory for rolling 3-month GDP development, and is likely to stay there, given that we still have not seen a reversal of the decline in PMI.
Now, check below the headline inflation rates for US and the Euro zone. It appears that from history, Europe lags the US by about three months, so we might still see higher inflation here n Europe for a bit longer, before it turns down. However, we have other forces in play here as well with electricity and natural gas prices still going through the roof across Europe, with the worst still ahead for winter when the demand is higher.
With regard to core inflation, having come down in the past few months over the summer, this indicator again (unexpectedly) jumped in August to 6.3% YoY versus expected 6.1%. Most of the increase is explained by rising Owners’ Equivalent Rent (the Shelter component), which makes up about 40% of the Core CPI basket. This indicator shows an estimate (perception) of what a homeowner’s rent would have been if he/she would have substituted their owned home to a rented equivalent. With rising housing costs (mortgage rates, energy prices, and heating costs), this indicator has been on the rise lately, and what is currently making up most of the rise in US Core CPI (see the left chart in the below pair).
Interestingly, ReSolve discussed this topic in their ReSolve Riffs podcast already in January 2022 in an interview with Jeff Weniger, and how the shelter component to CPI is lagging by perhaps 3-4 quarters (approx. 30 minutes into the podcast). Check that out if you want more details.
But also on the European side of the pond, core CPI is rising. Hence, we are in a rising price environment even if we exclude the more volatile CPI components of energy and food prices.
One main question currently is what it would take for inflation to again fall back to the long-term goal of 2% YoY. The headline CPI number has remained steady for two months already, as the month-over-month change was 0% in July and 0.1% in August, having been significantly higher earlier in the year (see the below chart).
Hence, what is needed in terms of inflation development going forward for YoY inflation to reach the Fed’s target? Bespoke Invest shared the below handy summary on Twitter the other day over what the inflation rate will be, depending on five different monthly headline CPI numbers. If we continue with 0.1% MoM increases, a) real yields will turn positive from March 2023, and b) 2% annual YoY inflation rate (+/- 0.5ppts) will be achieve in May 2023. It will thus be interesting to follow the monthly development going forward to see where we are heading inflation-wise and the monthly numbers are definitely something to keep an eye out for.
With the next two usual charts, we depict the trend in historical inflation and growth, as well as forward-looking expectations. Each data points are measuring the difference between the latest number and average of the previous 12 data points, where the larger dots being the latest numbers (the yellow diamond being the last measure).
Right: MoM change in %- of US 5Y Breakevens vs. PMI to the right (calculated as difference of datapoint for month n minus previous 12m average)
Yellow diamond marks the latest datapoint, with the previous in order of size.
Compared to previous months of these updates that I share, the inflation trend has come down significantly in August, i.e. that it is rising slower (the indicator is measuring the last print against a 12-month average), which reflects the pattern seen in the MoM inflation rate chart shown further above. This could indicate that most of the inflationary pain is behind us, as we are also seeing energy prices retracing the late-summer spike. See for example the Dutch TTF Natural Gas spot price chart below. The price is still at extraordinarily high levels from a historical perspective, but is not as bad (and improving) as it was in August. Note, however, that there remains a lot of uncertainty in this regard with the development in Ukraine.
The trend in growth, though, still does not look particularly rosy, as the growth rate is still below last 12-month average numbers, and the forward looking indicators (e.g. PMI) are not promising a turnaround any time soon. Hence, it is likely that the stock market should continue to underperform also going forward.
In other words, it appears we are still in the inflationary bust quadrant, but we should keep an eye out in coming months for the development on the inflation front.
Interpreting all charts above, we now have a good understanding of the current environment. Let’s therefore continue to look at my All Seasons Portfolio to see whether theory translates to reality.
If you are looking for getting started with your own All Seasons Portfolio and need some inspiration, check out my post on How to get started with the All Seasons Portfolio strategy. While stocks have been a great investment the last decade, there are no guarantees that this trend will last, as their continued success depends on several factors. Instead, consider diversifying your portfolio to include other asset classes, and benefit from the rebalancing period over the long-term, as described in this article.
August 2022 Portfolio Update
While July was a decent month for my portfolios, in August we again turned back to the too familiar path of negative returns.
Interest rates continue to rise and are expected to remain higher for longer (see my post about interest rate risk and what that means for asset valuations), which, in combination with lower expected growth, has cause broad sell offs in most asset classes. Stocks saw in July what appears to have been a bear market rally (this can only be confirmed in arrears) and have in August and September declined severely.
Only commodities contributed positively in August, but the increase was so small in relative terms that they weren’t even close to offsetting the deep drawdowns in other asset classes. Thus, the All Seasons Portfolio has continued to decline.
The only small consolation is that I am not alone. From the monthly update from Evoke Advisors, who manage two Risk Parity ETFs in the US that have similar asset allocations as the All Seasons Portfolio (see RPAR and UPAR; only available in the US) have had same drawdown levels as I have. While I would of course had liked to see my portfolios performing better, being alone in a drawdown is psychologically hard.
If we start with my eToro portfolio, which is an All Seasons Portfolio that is levered 1.34x times, the portfolio declined 4% in August.
Note also that this portfolio is denominated in US Dollars, which also means that my losses in EUR (and my own Swedish Krona; SEK) are less severe. Still hurts though.
As mentioned already, almost asset classes saw negative returns this month, and here below is how each contributed to the negative performance of the portfolio. Only commodities saw a slight increase, but had started to fall back toward the end of the month (compare with the above chart).
The allocation of this portfolio has seen a heavier tilt from stocks and nominal bonds to commodities, gold, and TIPS as part of a dynamic tilt I implemented in August to scale into alternatives when inflation is rising. This is based on a simple model discussed by AQR which implies that if inflation is rising and stock-bond correlation is increasing, an investor may expect higher portfolio returns by allocating to inflation biased assets, as rising inflation hurts both stocks and bonds. You can read the AQR article on their site where this concept is explained.
Additionally, I have decided to tighten the rebalancing span from previously being 20% of the aimed allocation down to 10%. This means that if stocks go from making up 30% to 33%, this triggers a rebalancing, instead of 36% in the past. My reasoning behind this is that during higher volatilities between assets, we could capture more of a rebalancing premium by rebalancing more frequently in markets that move up and down a lot, instead of waiting until it hits the marks on broader spans.
If you are already on eToro, make sure to follow me there too, as I from time to time share brief updates there directly about that particular portfolio. The updates I share on this blog will however remain deeper and more insightful. Otherwise, make sure to click the banner below and create an account, (and support the upkeep of this blog financially at the same time by using the affiliate link!).
Follow me there by finding user Allseasonsport. And feel free to copy my portfolio there with a small amount of your portfolio if you want a more hands-off approach to risk parity investing. I do all my trading there in a systematic and rule-based manner, and already have 13 copiers (excluding friends and family) at the time of writing. I very much like this copy investing functionality, as it makes it easier to follow other people’s strategies, while the investors like myself that are copied have skin in the game as all trades are done with my own money.
As for my DEGIRO All Seasons Portfolio, August was also not that good of a month, with a -4.27% decline over the month.
As for portfolio allocation, I am near my aimed weights, but remain overweight in TIPS vs. LT Treasury Bonds in this inflationary environment, as you will see from the below charts.
Over the last 12 months, this All Seasons Portfolio is now outpacing the stock market over both the last rolling 3 months and 12 months with lower volatility. Over the 3-month period, stocks have reversed their July rally in August, while the ASP drawdown has been shallower so far.
Here follows a chart of how each asset class performed over the month. As opposed to the corresponding chart I showed further above for my eToro portfolio, here gold joins commodities as a positively returning asset class in August. This is explained by the USD strengthening against most other major currencies and gold lately. Gold, on the other hand, has been performing decently when measured in for example EUR, so while it seems to have lost its glimmer as an inflation hedge when looking at its price in USD/oz, it has added value to a EUR portfolio.
Zooming out to a 3-month chart of each ETF, the main outlier is Bitcoin that has fallen off a cliff this summer (luckily my allocation is very small), while VIX has again started rising in August (blue line) after a quiet summer.
Lastly, as usual, here is the table of my ETFs and the changes laid out in table form.
|UBS LFS Bloomberg TIPS 10+ UCI ETF(USD)Ad
|UBS LFS-Blmbrg Eur InflLnk10+ UCIT ETF(EUR)Ad
|iShares $ Treasury Bond 20+yr UCITS ETF EUR H D
|LT Treasury Bonds
|Xtrackers II Eurozone Gov Bond 25+ UCITS ETF 1C
|LT Treasury Bonds
|Wisdomtree Us Treasuries 10Y 3X Daily Le
|LT Treasury Bonds
|Market Access Rogers Int Com Index UCITS ETF
|JPM Global Equity Multi-Factor UCITS ETF - USD acc
|Lyxor S&P 500 VIX Futures Enhcd Roll UCITS ETF A
By the way, this could also be a good time to mention that I have recently started a Wikifolio profile, where I also will be managing an All Seasons Portfolio. Wikifolio.com is, similar to eToro, a social trading platform but where you can track portfolio via regular brokers (currently brokers with activity in Germany, Austria and Switzerland such as 1882direkt) by investing in certificates listed on Börse Stuttgart (one of Germany’s major stock markets) and issued by Wikifolio’s partner Lang & Schwarz. I have already launched an Optimal Commodity Strategy that you can make a reservation for by registering and searching for my profile RiskParityNick.
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We’ll catch up soon for the next update!
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