Last week's rate-driven selloff, which not only slammed stocks but also resulted in $880 billion in mark-to-market losses for fixed income investors as the US "VaR shock" spread across the globe, was unique in that it hammered returns for both stocks and bond investors. In fact, as shown in the chart below, the aggregate weekly loss was -3.3%, the fourth largest of the year.
There were several other unique features to the last week's selloff - which was catalyzed by the growing "decoupling" between the US and global economy - one of which was that the majority of the YTD increase in rates has come from rising real yields, which has risen over 60 bps since the start of the year.
And, as we discussed previously, what made last week's selling particularly acute is that the speed of the rate move surged...
... in particular for long-dated inflation-linked bonds, and weighed on equities with balanced 60/40 portfolio performance hit especially hard.
At the same time, EM and tech also struggled, and the rise in yields has supported a rotation from growth to value and from staples to financials.
But perhaps the most notable consequence of last week's abrupt rise in bond yields pushed the equity/bond yield correlation into negative territory (alternatively, the equity/bond correlation into positive territory), especially that including the 30y real bond yield. As a reminder, the last time this happened was in early February, during the VIXtermination crash, when yields shot up and sent the S&P into a near correction.
A key side effect of such correlation inversion points is that it tends to hammer risk-parity funds, and indeed, as Goldman notes, as a result of last week's events, a simple US risk parity portfolio displayed a negative weekly return at the lower end of its historical distribution (2nd percentile since 2010, Exhibit 3). In fact, as Goldman notes, last week US risk parity strategies displayed one of their worst performances since 2010.
And while last week's events were reminiscent of the late January market meltup which ended with a bang (to the downside), Goldman adds that this type of event, where rate rises have negative spillovers on risky assets, "are not so unusual in a late cycle phase as central banks want to normalise policy." Of course, what has been rare in the past decade is central banks wanting to normalize policy, which is why markets were surprised by the outcome.
That said, Goldman reminds an entire generation of traders who have yet to live through a rate-hike cycle that during monetary policy tightening, equity multiples have generally decreased and earnings growth has had to drive positive equity returns. Which is also why the company profit story is so important for stocks.
What happens next? As has been the case for all of 2018, Goldman remains overweight equities as the bank's Economists think growth will stay healthy, "allowing risky assets to eventually digest rate increases," but each sharp increase in rates will likely drive initial indigestion. As such, the key indicator traders should keep an eye on is rate vol:
From here we think both the level and volatility of rates will remain key. Despite its spike last week, rates vol remains well below its long-term average as inflation uncertainty is low.
Risk parity, and balance portfolio hits aside, Goldman's rates team remains sanguine and expects only a gradual increase in US bond yields from here, but cautions that non-US bonds in particular may be a less effective hedge than in the past and potentially could drag down multi-asset performance. Which is why to hedge against such risk, the bank now recommends a broader diversification including commodities as a potential hedge (the bank is now overweight commodities, which means that its prop and flow desks are selling to clients as the bank no longer sees much more upside for its own accounts), as well as tail risk management via volatility and momentum-based strategies.