Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real-time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.
Today, we’ll take a step back from our granular tracking to address the bigger picture for asset allocation, as we think it is one of the most undercovered aspects of the current investment landscape. We’re currently in one of the most challenging environments for risk assets on record, with stocks and bonds experiencing losses from their highs. Below, we show how unusual it is for stock and bond losses to coincide this way, from 1971 to the present.
As we can see above, these periods are indeed anomalous and create a challenging environment for most traditional investors - who mostly have allocations to just stocks and bonds. Over the last 40 years, this conventional approach has served investors well - as stocks and bonds have both been supported by a secular decline in interest rates, which we show below along with our estimates of the market-implied regime:
Market movements over time reflect the underlying demand and supply dynamics in the economy. Using our understanding of this pricing, we can extract information about what markets are telling us about the current economic environment, i.e., the market regime. Based on our regime recognition, we can be in one of 5 regimes:
- (+) G (-) I: Rising Real Growth, Falling Inflation
- (+) G (+) I: Rising Real Growth, Rising Inflation
- (-) G (-) I: Falling Real Growth, Falling Inflation
- (-) G (+) I: Falling Real Growth, Rising Inflation
- (-) L: Tightening Liquidity
In reality, we can be in 8 different regimes based on the various permutations of growth, inflation, & liquidity. However, we compress the tightening liquidity environments into one regime to show the dramatic impact of tightening liquidity conditions on markets.
It is pertinent to note that since 1984, markets have spent 65% of their time pricing in falling inflation— an environment beneficial to both stocks and bonds. Stocks and bonds have opposing growth biases, i.e., stocks prefer environments where growth rises because earnings stay healthy. In contrast, bonds outperform when their fixed cashflows look relatively attractive, i.e., when growth falters. Thus, stocks and bonds have been extremely good diversifiers. However, while stocks and bonds have opposing growth biases, they have the same inflation bias— they need stable inflation to perform well. Therefore, when inflation becomes a dominant force in the economy, stocks and bonds perform poorly, both individually and together in a portfolio.