Regime Shift Coming?

Regime Shift Coming?

April 19, 2022
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Long-term trends – like the rules of investing – tend to break when there’s a regime shift.

These new trends can last for years, if not decades.

So, it’s important that investors know how to recognize and adapt to these shifts.

According to S&P Global – the famed index and research provider for market barometers like the S&P 500 – a “regime change” is a shift in the interactions of various parts of the economic or financial system.

The far-reaching effect of the regime shift I've been writing about this past year is starting to gain traction.

Interest rates have broken out and appear unstoppable.

Back in February 2021, I noted the confluence of trends favoring gold. Gold is up 11% vs. the US dollar since then. 

Last October, I noted the opportunities outside traditional stock market investments.

Then on March 27th, I followed up with, “...bonds are a drag on performance...with negative real yields”

Since then, in just three weeks, iShares 20 Plus Year Treasury Bond ETF (TLT) has dropped over 5%, while gold rose over 4%.

But this might just be the beginning…

You see, when an economic regime change occurs, the trends that unfold produce more than just short-term gains… they last for years.

One of the hallmarks of a regime change is when traditional economic relationships begin to break down.

We’re seeing this now.

We may be seeing a multi-generational trend in declining interest rates about to break… 

Now, the market is confirming this.

Take a look at this chart. This breakout in interest rates looks like it’s only in its early stages…

Source: Bloomberg

But this regime shift has more reach than just breaking down the gold/rates relationship…

Right now, bonds are falling with stocks – something I’m not sure the financial system is ready for.

The entire pension system – and many of the portfolio allocation models used by institutions – is predicated on the 60/40 principle. This principle states that 60% of a portfolio is allocated to stocks and 40% to bonds, or a variation thereof. (These variations often are dressed up and heavily promoted by the brokers as 'Target-Date Funds" or "Glidepath Funds"..in reality they are one-size-fits-all asset allocation tools essentially allocating between stocks and bonds.)

That’s because investors have grown used to seeing stocks get hedged by bonds during a weak market.

In fact, since we came out of the inflationary period of the 1970’s, all investors have seen is a market where both stocks and bonds rise.

This has led to diehard institutional allegiance to this style of portfolio management.

But the traditional “flight to safety” trade just hasn’t been there lately… when Treasury bonds rally when the markets turn weak.

Given this massive breakout in rates, I’m not sure where investors will get their returns in this environment. It certainly won’t be from traditional money managers who rely on principles like the 60/40 rule. 

Again, we saw this coming some time ago, writing about its demise.

We were not alone.. Bank of America made the case back in 2019..."traditionally safer assets like bonds have grown in popularity and helped create a “bubble” in the bond market that threatens to derail returns for investors who maintain a typical 60-40 split, according to the B. of A. analysis." 

Mortgage Rates Rising

The national average rate on a 30-year fixed mortgage went up 28 basis points in the last week, according to Freddie Mac. It’s now over 5% for the first time since 2011.

Remember, buying mortgage-backed securities was a big part of the Fed’s pandemic Quantitative Easing (QE) program. Without the prospect of that, the mortgage market is already pushing rates higher.

It’s not like the Fed has quit QE cold turkey, by the way. Even though the latest consumer price inflation (CPI) figure came in at 8.5%--the highest since 1981—the Fed’s balance sheet grew to a record size again this week. It’s now at $8.965 trillion. The effective Fed Funds rate, the price of money, is still 0.20%

Source: www.stockcharts.com

The Fed hasn’t even begun actually doing anything. But as the chart above shows, the bond market is already in trouble. The broadest measures of the bond market, which include investment grade corporate bonds and government bonds, are down 10.3% from their peak in August of 2020. At 617 days, it’s the longest and largest correction in the bond market in a generation.

The chart above shows the performance of two exchange traded funds (ETFs) in that time period. First is TLT, the iShares 20-year plus bond ETF. The second is TBT, the ProShares Ultra Short 20-year Treasury ETF. TLT, which is an equity proxy for longer-maturity government bonds, is down 27% from the high. That’s its largest drawdown since the security began trading in the early 2000s.

Investors should ask their money managers how they plan to deal with this changing tide.

We’re still in the early stages of this development. So, investors still have time to get ahead of this. Shorting bonds through the iShares 20 Plus Year Treasury Bond ETF (TLT) is an easy way to do it.

But we are risk-averse, defensive asset allocators. 

Our preference is to avoid bonds altogether in this environment, and to seek out substitutes which are superior to bonds. 

The largest asset manager on the planet is Blackrock. A recently-published study, Retiring with confidence: A case for Fixed Indexed Annuities (FIA) in Accumulation, concluded:

  • An FIA allocation offers greater upside in the “median” scenario when suitably funded.
  • An FIA allocation reduces extreme bad outcomes in balanced portfolios.
  • FIAs improve median and worst outcomes for conservative and cash-heavy portfolios (assuming liquidity needs have been met).
  • Incorporating an FIA with an underlying volatility- controlled index can help provide more certainty around future portfolio values.

More from the study...

"One of the key issues facing retirement savings is sequence of return risk. The most critical period for mitigating this risk is in the few years leading up to, and the first few years during, an individual’s retirement...the “retirement red zone.”

https://www.sglfinancial.com/blog/beware-of-the-retirement-risk-zone/

If a high proportion of negative returns occurs during this period, it can have a long-lasting, materially negative effect on the rest of the individual’s retirement years — potentially reducing the income an investor can withdraw over their lifetime.

While a negative sequence of returns compounded by ongoing withdrawals can quickly deplete a portfolio, a positive sequence of returns can quickly propel the portfolio ahead, potentially creating substantial excess accumulation. From an investor’s perspective, an ideal portfolio would be one that mitigates the negative sequence of returns, while capturing any positive sequence of returns the market has in store.

Our research suggests that incorporating an FIA can allow for consistent equity exposure in this ‟retirement red zone” to help capture upside potential while also mitigating downside sequence of return risk.

Retirement portfolios designed for investors in the “retirement red zone" are necessarily de-risked. We support this conventional wisdom. However, given the challenging forward-looking return expectations for equities, and low bond yields, it is important to consider complementary product options that can preserve the desired characteristics of retirement portfolios. FIAs may be a good candidate to help investors with protected growth leading up

... in this case study, we have shown that after addressing all these concerns for the investor, an FIA acts as a risk mitigation asset while enabling participation in positive market performance."

Finally, from Forbes:

If interest rates continue to rise, the value of bonds and bond funds will decline.

A recession also will cause losses in high-yield bonds and even some investment-grade bonds.

Fixed annuities and fixed indexed annuities offer several advantages over bonds and bond funds, while maintaining the diversification benefits.

The biggest advantage is that the insurer guarantees the value of your principal. Even if interest rates rise, the value of your principal remains the same. In addition, you’ll earn interest on the principal.

The purpose of this article is to point out fundamental shifts in the market...potential generational shifts. It is not to predict. Those who are aware and who prepare are much more likely to continue to prosper during these changing times. Those who stick with "conventional wisdom" may suffer the consequences of not adapting. 

The quotation misattributed to Charles Darwin comes to mind, "it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself."

Don't predict. Prepare. 

Contact us to learn how to apply these strategies to your portfolio. 

Hypothetical performance has inherent limitations. Such results do not represent actual trading, and thus may not reflect material economic and market factors, such as liquidity constraints,
that may have had an impact on our actual decision-making. No representation is made that a portfolio will achieve results similar to those shown, and performance of actual portfolios may
vary significantly from the hypothetical results. No representation is made as to the accuracy or completeness of the analysis shown in this material or the validity of the underlying methodology, and results are provided for informational purposes only.