Some quick background on the macro. Let’s look at the potential impact on a Trump re-election if he does what he is talking about on tariffs. Roughly speaking to set the stage, in President Trump’s first term he placed a set of duties on Chinese products in the America First economic policy to shrink the trade deficit and rebuild the U.S. manufacturing base. The world generally operates under large multilateral trade deals; he wanted to move to more bilateral deals and renegotiate the large deals. Exit TPP, redo NAFTA for example. Tariffs were planned/enacted on a variety of goods imports across finished products and raw materials: steel, washing machines, solar panels, flat screen TVs, batteries and many more Chinese goods in response to IP theft. Retaliatory measures from partners ensued, escalations etc. At the same time, he leveled lots of (correct) charges of currency manipulation by trading partners. Short version that underpins President Trump’s thinking – countries that keep their FX weak increase the attractiveness of their products at the expense of others, cause large trade surpluses, encourage overproduction/under consumption in the country with weak currency and underproduction/overconsumption in the strong currency country. In single product basic terms – if China keeps its currency very cheap it makes washing machines produced there unfairly cheap vs those produced in the U.S. Over time it is the currency naturally strengthening that should close that gap – keeping it weak on purpose as China does/did prevents that natural correction. When you zoom out to the macroeconomic level – the important part is China’s currency manipulation leads to not just exporting cheap washing machines but exporting unemployment from China to the U.S. as manufacturing jobs slowly leave the country due to U.S. products being unnaturally uncompetitive. Clearly it is impossible for all countries to run trade surpluses, someone must run the corresponding deficit, so the practice is damaging. At the same time, Trump discouraged companies from moving production overseas with reduced tax incentives via BEAT and GILTI, reduced domestic corporate tax rates, and used the bully pulpit to shame those that did. Some deal making ensued.

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About a year ago we wrote about Inflation Regimes and Return Distributions. The piece referenced an excellent chart we first saw from Goldman Sachs showing the Equity/Bond correlation vs realized US CPI. The negative correlation in the period since the late 1990s occurred in a world of low and stable inflation. The prior period in the chart, from 1970 to 1998 showed a period of higher than target inflation and a steadily positive correlation of stocks and bonds. Many portfolio strategies have been built with this negative correlation as the bedrock. It worked as the dual mandate acted like a single mandate on unemployment- the inflation side of the mandate could be safely ignored. Economy weakens, equity markets weaken, Fed cuts rates, bonds rally. Became self-fulfilling for a long period of time.

When inflation came back with a vengeance driven by pandemic supply chains getting overwhelmed with fiscal and monetary stimulus, then exacerbated by geopolitics and war, stocks and bonds fell together, partly as the starting point for yields was so low and durations so high. It depends exactly where you draw your lines, but long duration bonds – a diversifying asset relied upon to cushion equity markets – hit a drawdown approaching 50%. Traditional portfolios, built on that bedrock regime, only had one side of the distribution in one asset class to help diversify stocks – positive bond returns.

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Below is a great chart from Goldman Sachs. It shows the low or negative correlation between stocks and bonds we have seen over the past few decades has been in part attributable to the low inflationary regime over the period. This makes perfect sense given the way monetary policy has operated over the last twenty-five years, counter cyclical policy is very effective in periods of low and stable inflation. When equity markets start to become concerned about recessions ahead, earnings expectations reduce and valuation multiples contract. Stock prices fall. Bond markets typically would then anticipate the increased chance of the standard monetary policy response; cutting interest rates to spur economic growth. Bond prices rise. That explains the light blue dots below. The dual mandate was really a single mandate on unemployment, as the inflation side of the mandate was not biting.

On the other hand, periods of higher inflation have historically resulted in positive correlation between stocks and bonds, represented by the dark blue dots above. During periods of higher inflation, you tend to see rising interest rates, knocking bond prices down and putting pressure on equity multiples. It is much harder for monetary policy to operate in higher inflation environments to combat slowdowns, as the option of cutting interest rates is less easy. The two sides of the dual mandate are in conflict.

Sounds a bit like 2022. High inflation led to a more rapid rise in interest rates than expected, doing a lot of damage to long term bonds that were trading at very low levels – the US10 year ended 2021 at 1.50%. Equity valuation multiples were repriced lower as rates went higher. Stocks and bonds both went down. Portfolios built using bonds to diversify stocks, sometimes with leverage, saw some of the worst returns in decades.

While the long side of the return distribution has dominated since 1998, a return to higher inflation expectations, as seen from 1970 to 1998, requires the investor to consider the other side of the distribution when considering diversifying strategies.

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