“The interest burden of the debt is at what I would call normal historical levels.” Janet Yellen. June 2024.
US Treasury Secretary Yellen (Professor Yellen, as we know her) gives a masterclass in obfuscation, maybe even so far as gaslighting, in the Fox News interview inside the above linked story. It is no easy trick to describe the below as being within “normal historical levels”.
Figure 1: US Govt Interest Expenditure
Source: Bloomberg
We can broaden that picture by including the US Federal Debt/GDP and the yield on 2yr Treasury Notes, a proxy on the cost of fresh debt issuance to fund rollovers and ongoing deficits.
Figure 2: US Govt Interest Expenditure (white), Debt/GDP (purple), and 2yr Treasury Yield (yellow)
Source: Bloomberg
Some might argue that the only element remotely approaching “normal historical levels”, in the above picture, is the 2yr yield. Debt/GDP and interest expenditures are not at “normal historical levels”.
Professor Yellen’s spin hasn’t been helped with the recent announcement from the Congressional Budget Office that they are ratcheting up their forecast for fiscal 2024 deficit to $1.915 trillion, a mere 27% increase from previous forecast just back in February.
“The US budget deficit will jump to $1.915 trillion for fiscal 2024, topping last year’s $1.695 trillion gap as the largest outside the COVID-19 era, the Congressional budget Office said on Tuesday, citing increased spending for a 27% increase over it previous forecast.”
https://www.cbo.gov/publication/60039
We can’t help but feel obliged to show yet again our simple “Fiscal Dominance” visualization.
Figure 3: Fiscal Dominance – US 5yr Treasury Issuance Size
Source: Bloomberg, Convex Strategies
Given the increased deficit forecasts, the significant overweight in Bills issuance, and the, at least for now, stable policy rates from the Fed, we could anticipate the targeted allotment of the 5yr to go yet higher in the upcoming Quarterly Refunding Announcement (QRA) at the end of July.
Few things better capture our view of the current fiscal circumstances, the world over, than Ben Hunt’s incomparable works around what he dubs the Common Knowledge Game, maybe more commonly known as ‘The Emperor’s New Clothes’. We have the good fortune that political events in the US transpired such that Ben was motivated to give us all (he opened this piece up from behind the paywall) a crystal-clear example of the Common Knowledge Game. This is a must read, focusing on the current US presidential election and the aftermath of the recent presidential debate but, for our purposes, we are interested in the broader application to the ongoing narratives by economic and financial policy leaders.
Joe Biden and the Common Knowledge Game – Epsilon Theory
“Even if everyone in the world believes a certain piece of private information, no one will alter their behavior. Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior.” Ben Hunt, June 2024.
We saw this in spades as policy makers spun their ‘transitory’ spell around their measures of inflation and continued to delude markets with forward guidance that all-time extreme accommodative monetary policies would not need to adjust, back in 2021 and early 2022. Everybody knew historical extremes in negative real interest rates couldn’t align to a return to stable price levels, yet markets continued for the longest of time to price in accordance with official policy guidance from the clothes-less PhDs preaching from the halls of central banks and government policy castles.
Having been front and centre of the ‘transitory’ deception, Professor Yellen (et al.) now want us to believe that previously considered absurd, and the provenance of banana republics, levels of debt/deficits/interest burdens are “normal”. Everybody knows this is not a sustainable scenario but, as Ben so nicely elucidates, we just don’t yet know that everybody knows.
Ben wraps up his note with his version of the Self-Organized Criticality phase transition theme, what he calls “The Great Ravine”.
“The Great Ravine is the end of an age. It is the end of the cheap money and cheap labor of easy globalization…. It is the end of trust in our most crucial institutions – all of them! – charged with the core social functions of public health, public education, public finance and public safety.” Ben Hunt, June 2024.
We have been discussing the themes of ‘fiscal dominance’ (“who’s going to own the 40?” https://convex-strategies.com/2022/09/16/risk-update-august-2022/) and ‘financial repression’ (“Is Sharpe World Closing?” https://convex-strategies.com/2022/10/18/risk-update-september-2022-is-sharpe-world-closing/) for quite some time. Lately, a lot more people are talking about it. What happens when everybody knows that everybody knows?
We said it rather bluntly to close out the above linked August 2022 Update:
“We find ourselves engaged on a daily basis in discussions about what can be done to replace the now discredited portfolio benefit of the fixed income component of the heretofore 60/40 Holy Grail. The world at large is quite actively trying to figure out what alternatives exist that can protect their equity/growth allocations. In the course of these sorts of discussions, some of which occur in public at conference events that we might participate in, we always like to pose the question that, while recognizing the obvious concerns about protecting the 60, has anybody thought about what the world at large is going to with the accumulated 40 that nobody wants any longer? Worth thinking about….”
We discussed ‘fiscal dominance’ at some length in our August 2023 Update – “Compounding, Imbalances and The Arrow of Time” (https://convex-strategies.com/2023/09/15/risk-update-august-2023-compounding-imbalances-and-the-arrow-of-time/). In this Update we discussed a wonderful paper on the topic, courtesy of the St. Louis Fed, authored by Charles Calomiris. If you haven’t seen it already, it is well worth a read.
“Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that ‘dominate’ central bank intentions to keep inflation low.” Charles Calomiris, June 2023.
This led us to our analogy, as introduced in our October 2023 Update – “The Hunger Games” (https://convex-strategies.com/2023/11/17/risk-update-october-2023-the-hunger-games/ ), comparing the evolving battle for ever scarcer supply of liquidity in the world of never ceasing demand for borrowing, and dubbing Janet Yellen as the Katniss Everdeen in today’s competition.
“In what is increasingly becoming “The Hunger Games” of tapping the dwindling marginal supply of liquidity in the system, we fully expect Secretary Yellen to play the role of Katniss Everdeen, with a near certainty of teaming up with her present-day Peeta, if things ever get out of hand, in the form of Fed Chair Jerome Powell. Janet will secure her funding one way or another…. The risk in this scenario is to everyone else, who also have historically large piles of debt to refinance at levels of interest rates now far different to what existed just a couple of years ago. This problem appears at a time when traditional holders, eg. Sharpe World institutions, are already choking on the existing unprecedented stock of debt, the risk of which has not only been vastly under-capitalized due to financial repression based regulatory risk constructs, but also aligned with accounting requirements that have allowed vast unrealized losses to accumulate to solvency-impeding scales.”
Every day we find ourselves responding to headlines, articles, papers, comments with the simple refrain – “Hunger Games”.
For example, see the below linked CNN Business story that references the recent IMF Report.
The world is sitting on a $91 trillion problem. ‘Hard choices’ are coming | CNN Business
“The International Monetary Fund last week reiterated its warning that “chronic fiscal deficits” in the US must be “urgently addressed.” Investors have long shared that disquiet about the long-term trajectory of the US government’s finances.”
Hunger Games.
The topic of fiscal dominance/sustainability came up very explicitly at the ECB Sintra Conference at the end of June.
Below is the link to the panel discussion with Fed Chair Jerome Powell, ECB President Christine Lagarde, and Central Bank of Brazil President Roberto Campos. We have pulled out some of the relevant quotes on this topic and noted the time stamps below but, if you have time, the entire hour is worth a watch.
ECB Forum on Central Banking 2024 – Policy Panel (youtube.com) ECB Sintra 2024
Brazil CB Campos, 18:10. “As you go for longer with higher rates, and much higher debt, you start extracting liquidity from the market and eventually you are repricing that liquidity. It could be just a temporary adjustment in EM or it could be the beginning of a more profound movement.”
President Campos is from one of the non-dominant districts and would prefer not to have to compete in the Hunger Games.
Lagarde, 32:50. “Fiscal matters enormously. It matters in two different ways. It matters from a conjunctural type of way. Thank goodness the European authorities have agreed on the fiscal governance that will take over after the Growth and Stability Pact has been replaced, has been suspended and now completely replaced. So, there is a framework within which members of the European Union have to operate, have to control the direction of their debt, have to make sure that it is sustainable going forward through the efforts that they deploy and have to keep their deficit on watch. With enough flexibility, and that’s the second part of fiscal spending that I’m concerned about, with sufficient focus on productivity, on growth, of investment that will be conducive to both. My hope is that, in addition to operating within the European fiscal framework, which has been agreed by all European members, in addition to that countries will actually look at the structural changes that they have to, either continue to have in their arsenal of tools, but also that they will continue to improve going forward, because I regard that as critically important for productivity purposes, which we are lagging behind and have been lagging behind for a long time. So, we are not so worried about fiscal expectation, but we are very concerned about the fiscal rules that have to be respected within the European Union and the structural reforms that will be conducive, hopeful, to productivity improvements going forward because that is the only way for Europe to remain strong and thrive in those changing circumstances and transformations that we have talked about.”
President Lagarde is the master at assuring us of the glamor of the new clothes adorning the emperor. Of course, the fiscal circumstance is sustainable because they have rules that make sure it is sustainable. She does catch herself and feels obliged to drop in that said previous set of rules are currently suspended since, when the pressure arose, they chose not to follow those rules. But they have all agreed to a new set of rules that are soon to be codified and will accommodate the revised set of circumstances, everyone will follow them, and will restore the sustainability that was presumably never really lost anyway. There is no accountability in central banking. Ms. Lagarde is like the benefactor of a whole bunch of weak competitors in the Hunger Games but always insistent that she will give them all an equal chance at surviving. That, obviously, can’t be true.
Jerome Powell, 35:35. “The US is running a very large deficit at a time when we are at full employment. The level of debt we have is not unsustainable but the path that we are on is unsustainable. That is completely non-controversial. I would have thought this is something that should be a top-level issue, and you do hear this from a lot of elected officials, but it should be a real focus going forward. How do we get back to a sustainable path? You can’t run these kinds of deficits in good economic times for very long. In the longer run, we will have to do something sooner or later, and sooner would be better than later.”
Chair Powell comes forth with a little more honesty. He is truly playing his Peeta role, arguing that we should really try to avoid the Hunger Games.
Before the moderator can move on, President Campos requests the chance to reiterate his view from one of the remote districts and it is a full-on Hunger Games recital.
Campos, 36:50. “Let’s do a basic exercise. If you look at the total debt combined, just sovereign debt, of US plus Europe plus Japan, that’s 64% of total global debt. That went, in terms of cost of service of that debt, it went from 1.1-1.2% before the pandemic to around 3.3% now. But then you add the 25% of GDP to that debt, which was the cost of facing the pandemic. So, we have a much higher debt and a much much higher cost of servicing the debt. I think there is an aspect globally, that is the extraction of the liquidity, cumulatively, will have an effect in the market that sometimes is not pricing correctly. What we have to do right now, we have to pay for the cost of the transfer programs that we did. We need to pay for the cost of the green transition, which is somewhat expensive. We need to pay for the cost of the fragmentation, which if you look at the surveys, it’s very costly for companies and for the governments. We need to pay for the cost of low-income countries that spent very little during the pandemic and now need support. We need to pay for the cost of demographics and there is a surge of consumption of energy that needs to be paid because of innovation. We have a lot of bills to pay. We are at the highest level of debt we have had in a long time. I think sometimes it’s time for us globally to think about a way to get to some kind of a stable trajectory of the debt in the next couple of years. It’s not one country or the other. It is something that we need to do collectively, because the global debt is very high, and it is going to start taking a lot of liquidity from the markets. The ones that will feel the effect are not the advanced economies, they are the emerging markets economies, and the low-income countries are feeling that effect already. I think the market was mispricing a little bit the fact that, if you have higher rates for longer, the effect from extracting liquidity, depending on how much longer you’re going to have higher rates, the risk is higher than what the market is pricing.”
That is exceptionally well said and likely reflects the thoughts of any indebted EM country that can foresee the crowding out effect of the insatiable appetite to issue debt by the big boys.
Hunger Games.
Mr. Campos has figured out what Professor Falken’s computer program was able to learn in the classic 1983 movie, “WarGames”.
“The only winning move is not to play.” Joshua AI computer system, 1983.
WarGames (11/11) Movie CLIP – The Only Winning Move (1983) HD (youtube.com)
As we keep saying, the first player to reduce bond issuance wins.
The subject was also taken up, in quite some detail, in the latest BIS Annual Economic Report.
BIS Annual Economic Report 2024
The first paper, “Laying a robust macro-financial foundation for the future”, gives a high-level overview and touches only briefly on the ‘fiscal dominance’ issue.
I. Laying a robust macro-financial foundation for the future (bis.org)
“Fiscal consolidation remains essential to support disinflation and restore debt sustainability… this would help relieve pressure on inflation and lessen the need to keep interest rates high, in turn helping to preserve financial stability… The window of opportunity to take decisive action is narrowing. For example, as of last year, AEs would have needed to keep budget deficits below 1.6% of GDP to stabilise public debt; today, that number is 1% of GDP.” BIS, June 2024.
Just for some perspective, according to Bloomberg, current levels of government deficits for some notable names are:
- US: -5.56%
- Japan: -3.32%
- France: -5.50%
- UK: -2.30%
- Germany: -2.50%
- Italy: -7.40%
- Spain: -3.60%
- China: -4.58%
- India: -5.97%
- Brazil: -9.57%
That list captures pretty much everybody that is in the $1trillion and above club of outstanding government debt.
Graph 16 in the paper (Figure 4 below) gives a very nice visual representation of the ‘Common Knowledge Game’ dynamics of the current situation. The two charts on the left show the clear sustainability issue of the current trajectory, call them the everybody knows charts. Meanwhile, the chart of the far right shows, at least for the advanced economies, the complacency in market pricing, call it the everybody does not yet know that everybody knows chart.
Figure 4: Debt/GDP, Deficit status, Sovereign Credit Markets
Source: BIS, IMF, S&P Global
The second paper, “Monetary policy in the 21st century: lessons learned and challenges ahead”, is the one worth really digging into. This one comes from one of the rare voices of reason in the world of economic policy sorts, Claudio Borio. Sadly, for the world, Claudio will be retiring from the BIS later this year. There is a lot worth reading in this note, as ever with Claudio’s work, but for our purposes we will focus on the fiscal dominance related comments.
II. Monetary policy in the 21st century: lessons learned and challenges ahead (bis.org)
Claudio, as ever, does not mince words.
“… longer-term government debt trajectories pose the biggest threat to macroeconomic and financial stability… Even if interest rates return to levels below growth rates, absent consolidation, ratios of debt to GDP will continue to climb in the long term from their current historical peaks. The increase would be substantially larger if one factored in the spending pressures arising from population ageing, the green transition and higher defence spending linked to possible geopolitical tensions. The picture would be bleaker should interest rates settle above growth rates – something that has happened quite often in the past and would be more likely should the sovereign’s creditworthiness come into doubt at some point.”
“Higher public sector debt can constrain the room for monetary policy manoeuvre by worsening trade-offs. It can make it harder to achieve price stability. Higher debt raises the sensitivity of fiscal positions to policy rates… High debt can also threaten financial stability. Losses on public sector debt, whether caused by credit or interest rate risk, can generate financial stress; in turn, a weak sovereign cannot provide adequate backing for the financial system, regardless of the origin of the stress.” BIS, June 2024.
The echo with what President Campos outlined above is very obvious.
Hunger Games.
Figure 5: Debt Projections for Advanced and Emerging Economies and Debt Service Cost
Source: Federal Reserve Bank of St. Louis, IMF, OECD, Bloomberg, LSEG Datastream, BIS
“…the past decade has shown the potential for the sovereign sector to cause financial instability, first as a result of credit risk (the euro area sovereign crisis) and more recently because of interest rate risk (eg. strains in the US banking sector in March 2023 or those in the UK NBFI sector in September 2022).” BIS, June 2024.
This, of course, aligns to one of our own oft stated aphorisms:
“Banks don’t go out of business taking risk. They go out of business levering things that they can account for as riskless.” Convex Strategies.
Claudio leaves us with this final little directive as relates to the fiscal challenge:
“Sustainable macroeconomic and financial stability will remain beyond reach if fiscal expansions are disproportionate, the sustainability of fiscal positions is in doubt, or prudential policies – both microprudential and macroprudential – fail to strengthen the resilience of the financial system.” BIS, June 2024.
How do Common Knowledge games come to fruition? Very slowly, then all at once.
It all comes down to the ever-growing imbalances in the complex adaptive system that is the global financial and economic construct. The US, as the keeper of the global reserve currency, acts as the core of the global nuclear reactor financial sandpile. That sandpile expands, aided and propped up by the tenacity of a multitude of interventions on behalf of the powers-that-be, all with the misspent belief that, by preventing and mitigating avalanches, they are make the sandpile safer. Eventually, inevitably, one last grain of sand will start an unforeseen, seemingly small avalanche, that will trigger the chain reaction across the connectivity of mass-accumulated fingers of fragility. We will get the phase transition, Ben Hunt’s ‘Great Ravine’, and the system will reset to a stable, natural, equilibrium.
Nobody can know when or where that fateful grain of sand will fall. All we can try to do is understand the imbalances that exist in the current existing state of things. The best way to guess where there might be imbalances worth paying attention to is to look where the greatest and longest efforts are being made to impose unnatural influence on market functions. We can think of three pretty obvious big ones.
- Japan. Multi-decade manipulation of monetary policy. ZIRP, NIRP, QE, QQE, YCC. They are now, ever so slowly, trying to back the train out of the tunnel they have been digging to nowhere. The obvious side-effect, and pretty clear indicator they are going too slowly, is the debasement of their currency, down nearly 60% against the USD since the beginning of 2021.
- China. The largest creator of centrally directed credit in the 10yr period post the GFC that the world has ever seen. They were able to do so courtesy of stringent controls on the currency market. The side-effect, currently playing out, has been a major debt deflationary environment that has wreaked havoc on previously inflated asset prices. Meanwhile, it has necessitated ever greater manipulations of the currency.
- Eurozone. Now into a multi-decade experiment on monetary union and internal currency peg, yet without fiscal or banking union. The side-effect, significant fragmentation with several key countries in a position that fiscal sustainability, without ongoing ECB support, is out of the question.
That is three out of the four largest economies in the world. All arguably battling to maintain major sub-sandpiles within the global whole, that are very late stage in their capacity to sustain these manipulations. They are all potential triggering avalanches to the greater whole, as well as being highly susceptible to other tremors in the big global sandpile.
One of those fingers of fragility that often gets discussed is the implication of the Bank of Japan (BOJ), notably the last major central bank actively providing liquidity into the Hunger Games arena, ending their era of JGB purchases and what that might mean to Japan Inc.’s holdings of fixed income securities around the globe. Will a necessity for Japanese institutions to absorb the ongoing supply of their country’s own government debt result in a repatriation of funds currently parked in overseas bond markets? Could such a thing trigger a chain-reaction as other governments need incentivize their own financial systems to re-emphasize scarce provision of liquidity to their own domestic competitors in the Hunger Games?
Maybe we will start to get some hint of this at the upcoming BOJ Policy Meeting.
Bank of Japan opens door for a hawkish double surprise | Reuters
Reuters suggests it may indeed be coming:
“The Bank of Japan is dropping signals its quantitative tightening (QT) plan in July could be bigger than markets think, and may even be accompanied by an interest rate hike, as it steps up a steady retreat from its still-huge monetary stimulus.”
Could this truly result in large holders of overseas bonds liquidating some of those holdings and bringing the funds back home to hold JGBs? This story on Norinchukin Bank makes us think it could be so.
Norinchukin sounds warning as higher-for-longer rates inflict losses – The Japan Times
“The agricultural bank surprised the market this week by saying it would sell $63 billion of low-yielding U.S. and European government bonds that had become unprofitable to hold after the firm’s shorter-term funding costs jumped.”
Hunger Games.
This also ekes into our softly whispered concern that we have dubbed “The Great Stop Loss”. Could something ever trigger a liquidation of the mass of bond holdings by Sharpe World regulated financial institutions that aren’t required to account for the accumulated unrealized losses? Whenever we whisper this, the risk that shall not be mentioned, there is the obvious pushback – why would anybody ever do that! We give our usual simple answer, probably because somebody decided to.
Unlike Bank of America and their willingness to carry their circa $130 billion unrealized loss on their Hold to Maturity portfolio of government bonds, Norinchukin does not have particularly sticky cost dollar deposits. Their sticky deposit costs are in JPY. They fund their USD bond holdings using FX swaps, the price of which adjust directly with changes in USD interest rates, and more so as the basis has continued to move against them. They can eat what is estimated at a $9.5 billion loss on these foreign bonds, swap the proceeds back into JPY, and buy JGBs that benefit from a positively sloped yield curve and take advantage of their own sticky cost of JPY deposits. They will be back to positive accruals on the banking book for the next calendar reporting period.
They may also help answer the question around who is going to step in as BOJ starts to step away as the main purchaser of JGBs. Expect the same from other quasi-policy type banks (eg. Japan Post) and NBFIs (eg. GPIF).
Again, these sort of major market-unwinds, if they happen, happen very slowly, then all at once. Fiduciaries that can mask risks and losses through generous regulatory risk and accounting methodologies, generally are very happy to do so. However, once the Common Knowledge Games burst, there can be quite the rush to the exits.
None of this changes anything about our perspective on how to properly construct investment portfolios. Portfolios should be constructed to both ‘participate and protect’. The two largest destroyers of compounding wealth that we see from invest managers, which are intimately linked to each other, are 1) bearishness, and 2) poor risk mitigation. The Sharpe World standard practice of driving without brakes (no explicit risk mitigation) and targeting average lap-speeds (expected returns), leaves investors forever susceptible to the siren-song of bearishness. In that world, risk management is about driving ever more slowly in anticipation of unknown but oft-predicted future bad patches. Proper investment management is all about building effective explicit risk mitigation, well-functioning brakes, that allow you to safely put more capital to work in participating investments, aka drive faster.
We saw the below article that serves as a basic example of the flaws of even supposed ‘advanced’ Sharpe World strategies.
The article notes that, since becoming an active manager in 2006, CPP has failed to keep pace with their own simplistic balanced portfolio benchmark.
“The news is not that the fund trailed its benchmark in its most recent fiscal year. The news is that it is now trailing it, on average, over the entire 18-year period since the fund, until then a small, low-cost outfit that mostly just bought indexes, went all in on active management… it confesses to having earned “negative 0.1% annualized or negative $42.7-billion since inception of the active management in 2006,” relative to the reference portfolio. Indeed: while the fund has earned 7.7 per cent annually since then, the reference portfolio has earned 7.8 per cent.”
To be fair, relative to much of the Sharpe World universe that we see, this is a pretty good result. They almost matched, over a respectably long sample compounding period, a reasonably aggressive benchmark. They even rank themselves second, in a chosen universe of peers, over a shorter 10-year period. Where the article focuses its criticism is not, per se, on the poor quality of the active investment management but rather on the accumulated cost of enacting it over the period. The article, referencing CPP’s own reporting, notes: “Over all, combining management fees, operating expenses and transaction costs, the fund’s expenses now exceed $5.5-billion annually – more than $46-billion in total since 2006.”
Still, it isn’t hard to proxy their return dynamics with some other version of an ‘advanced’ Sharpe World investment strategy. As with most sophisticated pension funds this can be done with some form of a Risk Parity strategy. Conveniently, over their 18-year horizon terminating in March 2024 of active management, the S&P Risk Parity 10% Target Volatility Index (SPRP10T Index) has a CAGR of 7.9%, almost identical to their reference portfolio return of 7.8%. Close enough.
We can compare that to our standard hypothetical Barbell Racer, the convexity enhanced Always Good Weather (AGW) portfolio. This portfolio is simply constructed of a 40% allocation to vanilla beta in the form of the S&P Total Return Index (SPXT Index), 40% allocation to a proxy of juiced upside participation in the form of Nasdaq 100 Total Return Index (XNDX Index), and 40% (2x levered) allocation to explicit negatively correlating CBOE Eurekahedge Long Volatility Manager Index (EHFI451 Index) and assume annual rebalancing.
These two hypothetical proxies have roughly similar Max Drawdowns (30.2% for AGW vs 31.2% for Risk Parity) but far less Downside Volatility risk for AGW (6.7% for AGW vs 9.8% for Risk Parity). This leads to a far superior Upside/Downside Beta (what we call a Convexity Ratio) for AGW (0.78 Upside Beta/0.60 Downside Beta for AGW vs 0.49 Upside Beta/0.66 Downside Beta, so Convexity Ratio of 1.8 for AGW vs 0.7 for Risk Parity). Simply put, a Convexity Ratio over 1.0 infers positive convexity in your investment portfolio. Obviously, the hypothetical CAGR, and as such the Terminal Capital, is far superior in the positively convex AGW portfolio (AGW CAGR of 12.2% and Terminal Capital of 806.86 vs Risk Parity CAGR of 7.9% and Terminal Capital 396.77)
Figure 6: Hypothetical AGW 40/40/40 (blue) vs Risk Parity (red). Apr ‘06 – Mar 24. Scattergram and Return Dist.
Source: Bloomberg, Convex Strategies
Figure 7: Hypothetical AGW 40/40/40 (blue) vs Risk Parity (red). April 2006 – March 2024. Compounding View
Source: Bloomberg, Convex Strategies
We have discussed ad infinitum what drives this sort of compounding impairment and agree with many of the points made by the author of this article in The Globe and Mail. We laid it out very simply way back in our July 2020 Update – “The Destruction of Compounding” https://convex-strategies.com/2020/08/27/risk-update-july-2020/. We noted these simple points back then:
- Fees and expenses. Costs in general, but particularly fees that are linked to correlated returns. Paying away 10-20% of the upside returns of correlated risks, but keeping 100% of the losses, is a sure way to impair compounding.
- Investment exposures with bounded, seemingly uncorrelated, upside, but unbounded correlated downside, eg carry trades, short volatility, levered low vol type strategies.
- Short term return objectives. The incentivized targeting of probabilistic “expected returns”, as opposed to long term compounded returns, creates a focus on performance at the centre of the probability distribution, not the wings.
- Pro-cyclical Gaussian based risk methodologies, eg. Value-at-Risk type constructs that encourage risk taking when valuations are high, and vice versa. Think of it as negative gamma risk management, buy high and sell low.
We are convinced that it really is that simple.
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