Lending markets

3 things I think about: bonds, bear markets and ESG

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Here are some things I think I think about:

1) Is the Bond Bear really over now?

JP Morgan issued a low call in bonds yesterday. The basic thesis is that the Fed shocked financial markets with its aggressive stance on rates and the necessary effect will ripple through the economy and inflation data over the coming year. I largely agree with that. In February I said that rates would likely peak at around 2.5% in year 10 and are currently at 2.85%, so we went a bit further than expected. I was actually shocked by the Fed’s aggressive rhetoric and to be honest I find it a bit reckless and so behind the curve that it creates a very serious recession risk. My general thought is that we are approaching the level where the 30 year relative mortgage (5-6%) is putting a damper on the housing market and going much higher would put the economy into recession.

My biggest concern now is that the aggressive positioning of the Fed creates the risk of a hard landing. In other words, they were behind the curve of rising rates, then inflation surprised them. So now they have to try and make up for lost ground, but in doing so they are shocking the economy inside a very brief window that has involved $35 billion in global asset price declines and growing unaffordability in real estate and other areas of the credit markets. So instead of this kind of methodical, surgical relaunch, we just rip off the bandage.

Either way, all of this means that the worst of the bond bear market is probably over. Or, at least, we won’t see the same level of volatility in high-quality bonds because interest rate risk has diminished. Of course, we now have to ask ourselves whether interest rate risk will turn into credit risk, but that is a whole different matter.

2) Bonds ALWAYS work.

Speaking of obligations, they always do their job. The S&P 500 is down 18.2% since the start of the year. But a 50/50 stock/bond portfolio was down just 13.4% as bonds outperformed stocks by a wide margin despite the worst bond market bear market in decades.

S&P 500 and bonds

This is massively under-discussed in this market. Even with a historic decline in bonds, you still get close to 5% outperformance through a diversified bond allocation.

And that should get even worse if the decline in equities continues, because bonds, in the long run, are just flows of fixed-income securities. The longer you hold them, the less volatile they become. The only reason the first quarter was such a volatile time for bonds is because we experienced a historic high in interest rates in a very short period of time. But now it is becoming clear that the economy is slowing down and inflation should moderate. On the contrary, the likelihood of policy easing now increases as the risk of recession increases. This means that if the stock market continues to remain difficult this year, the outperformance of bonds is likely to become even more exaggerated.

In fact, I’m relatively excited about bonds for the first time in a long time. I had been writing for years that I struggled to build conservative portfolios that could meet a 4% drawdown rule, but with rates rising, that’s no longer an issue.

3) Virtue posting investment strategies.

I wrote a decent amount on ESG investing in the past. My general opinion is that you should not moralize your investment. In short, the only relevant metric to moralize investments is legality. If the business is legal, it is deemed moral by the government. For example, we could argue that Exxon Mobil is an immoral company because it uses fossil fuels. Sure, but XOM also helps make the fuel that literally powers much of the world’s economy. Or, a better example might be that XOM is now one of the biggest investors in renewable energy. We can moralize about how we subjectively analyze a business, but the reality is that “morality” is a big gray area and what’s moral to you might be immoral to someone else. And when you start to get morally emotional about your investments, you become a stock picker. And when you become a stock picker, you become someone who earns less after tax than someone who indexes. And then you moralize, in fact, it hurts your bottom line, which hurts your ability to do good in the world.

My general view of ESG investing is that it is primarily a signal of virtue. It’s a subjective approach to moralize some companies selling the appearance of “doing the right thing” when most of the ESG funds that exist are really just high-fee versions of index funds. And it’s no surprise that ESG funds were completely sabotaged last year as they dumped huge amounts of the market in what amounted to little more than a stock-picking game with higher fees.

Anyway, I was blown away by it all as I read how Tesla was dropped by ESG funds because they no longer meet the subjective criteria assigned by S&P. Or, in the same sense, please read this entire article if we have to moralize mayonnaise because it could be perceived as bad. Sigh.

Listen, don’t get me wrong. I’m not a bad person just because I defend Mayonnaise and Tesla. I don’t even like Mayo, but we have to be very careful how we mix our politics, our emotions and our biases with our investment strategies. There are good places to use your money in a morally conscious way – the stock market is not that place.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.