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Inflection Point

Checking in on the Global Market Portfolio

By Roman Eisele
Don't burn the boats

Q3 Global Market Portfolio Performance Shows Contraction, and Hints and More to Come

One of the more ridiculous things you see in the financial media is the constant publication of investment returns and references to them as something like a foot race. Lately we've been treated to analyses of large university endowment returns for the past year, with two areas of focus: Who of the super-large endowments is on top?, and Who of the super-large endowments didn't get trounced by the sub-scale endowments?

It's not puzzling why they do this. Who doesn't love competition? Who doesn't love a race? Also, Who doesn't love seeing the little guy beat the big dogs? The issue, of course, is that this kind of narrative fosters unproductive and risky thinking about investments and investing: it turns our attention from the long-term, which is the only appropriate timescale according to which we should judge investments, and it takes our eyes off of the most important aspect of investing, Risk.

Modern (and Post-Modern) Portfolio Theory are based on two quite boring but ingenious insights. The first is that portfolio diversification is a free lunch--we lower risk and thus enhance return by investing in assets that don't go up and down at the same time. The second is that we should focus not on a thing's return in isolation, but rather consider it scaled against the thing's risk.

Below we reproduce an approximation of the Global Market Portfolio (GMP) since January of 2020. The past three-and-three-quarters years has been an incredibly rich time to be invested because so many different economic environments have been crammed into one small sample: a huge exogenous shock, an inflation spike, economic expansion, and now economic contraction. We've seen low interest rates, normal interest rates, commodity price swings, and the introduction of novel technologies. What a time to be alive.

Diversification has been a millstone around the neck of most investor's portfolios

You can see how $10,000, invested on December 31, 2019, would have grown over the past period had you invested in a variety of different portfolios. This analysis is oriented toward the US-based investor, but the point is generally the same regardless of where you invest. If you invested in the S&P 500, which accounts for approximately 80% of the US stock market, your accumulated wealth would far exceed all other investments. If you had diversified that bet on US stocks (which is itself 60% of the developed world's stocks, with a .97 correlation to global equities) by investing in US bonds (represented here by the Bloomberg Aggregate index of bonds), your wealth accumulation would still have substantially outstripped much more diversified portfolios of investments (represented here by the Global 60/40 portfolio, and the Global Market Portfolio (GMP), which contains private investments as well*.)

But this only takes return into account. It is easy to see that the S&P500's returns are highly volatile, registering 23% over the period, whereas the GMP's volatility registers 11%. The depth of the S&P500's drawdown during the early days of the COVID-19 Pandemic (-31%) was far worse than that of the Global Market Portfolio (-19%). The S&P's worst day, a loss of 11%, was far worse than the GMP's, a loss of 6%. There was a time during this period when the equity investor was sitting on a loss of nearly a third of their wealth. Of course, as of the end of the third quarter of 2023, their wealth stood at a 40% gain. While most people would choose to risk a loss of 30% for a gain of 40%, that involved enduring a white-knuckle ride of 82%. The GMP investor, on the other hand, experienced a swing of 37%, with a terminal gain in wealth of 6%.

There are reasons to think that the gain in US equities is not durable, though we won't predict that they will not persist. The extraordinary outperformance of the S&P500 since the COVID-19 Pandemic has thus far defied gravity, and certainly there are some reasons to think that these companies really do operate according to a different set of economic laws.** That said, we think it's more likely that the inveterate optimists that set marginal equity prices have gotten carried away, and that these trees, too, will fail to grow to the sky. Indeed, in the chart below, we see that US Equities (in blue) have begun to act more like the other assets that comprise the GMP. Whether this is a temporary setback for the flying trapeze artist of the West, or presages things to come, only time will tell.

Diversification has been a millstone around the neck of most investor's portfolios

We Got Some Data This Week

First, and most importantly, GDP growth for the third quarter came in--and it was a scorcher.

At 4.9%, real growth in the United States was the fastest in a year, and suggests that whatever the Federal Reserve thinks it's doing to slow the economy just ain't working.

Growth was particularly hot in Q3, at 4.9%

Of course, that's not quite true. Growth was strong but came disproportionately from consumer spending and business inventories. The US Economy is weighted toward consumption, to the extent that almost 70% of economic activity is its result. The consumer spends, the market trends; the consumer stops, the market drops.

However, this is merely one method of measuring economic growth. GDP growth is a reliable indicator of economic activity, but it is derived from expenditures. Another method of measuring activity is to derive it from income. These two should generally provide the same picture, and when they don't, they usually converge. Indeed, if they didn't then one or the other wouldn't be a very useful tool to gauge economic activity.

Growth registered a more normal 2.3%

As you can see in the above chart, GDI growth actually fell to 2.3%. While the economy continued to grow, it did so at a far slower pace, and one which is closer to what we think of as the long run growth rate of the US economy. Further, when the expenditure and income approaches disagree, it is typically because spending is outstripping income--and the only way that this can happen is if the spending is being done from savings.

The Personal Saving Rate continues to fall...
...contributing to a fall below the fifteen-year average

If there were one reason that we might point to as to why the US economy avoided recession over the past year, it would be the high savings rate. This allowed Americans to continue to spend when they may otherwise have held back. Now that savings are nearly exhausted, we would ordinarily expect a pullback in consumer spending, and with it, economic growth. Though this is coming in the fourth quarter, which is Holiday time in the US and known for its high level of spend, consumption may well fall, and the first quarter post-holiday hangover particularly severe.

Personal Consumption Expenditures

Headline inflation, or inflation measures that include volatile components like food and energy--and shelter--came in at 3.6%, certainly higher than the Federal Reserve's target for price stability of 2%, but not far off of prints that we've become accustomed to over the past several months.

Inflation came in at a 3.6% annual pace, its range for the past few month

Stripping out Food and Energy, we see a picture emerge that suggests that the US economy is quite close to where policymakers would like to see it settle.

Removing the effects of food and energy volatility, a quiescent picture emerges

Removing outliers, we see that the inflation rate remains persistently high at 3.9%, although as we've mentioned in the past, much of this is due to the influence of owner-occupied housing, which is a controversial addition.

The Dallas Fed's Core Measure shows persistent high inflation

Stripping out Housing, inflation is probably running somewhere between 2.5% and 3%. The interest rate campaign has probably succeeded in taming rampant inflation, however the Fed faces a nagging last-mile problem: now that you're back in the neighborhood of where you want inflation to be, how do you get to two percent?

Just shy of 3%

Keep in mind that the Fed doesn't need to get inflation all the way down to its target in order to achieve its objectives of full employment and price stability. Two percent is not a magic number; if the US economy can grow at 3%, and inflation is 3%, then that's just fine. Also, the Fed understands that there is measurement error inherent to these approximations, and so isn't going to wring the last .25% or .5% out of the economy with a commensurately-sized interest rate increase. Given that business investment is falling, and other indicators are beginning to show a mixed picture of growth, the Fed will sit tight and resume its "wait-and-see" or "data-driven" approach. This may redound to the discomfort of some in the media and academic universe that like to opine on what the Fed should be doing, and who would like to see a more aggressive, more interventionist Fed, but the current chair Jay Powell is not the person to give it to them. Although this hot GDP print would seem to tip the scales toward a rate hike in November or December, the balance of indicators still shows that the economy is lacking direction, is likely to remain in a range, and it is as likely to contract from here as it is to expand.

Indicators remain pretty mixed as to where we go from here

This is pretty consistent with late-cycle dynamics: high growth, high inflation, faltering confidence, falling savings, and falling business confidence. This tends to show up in the indicators as volatility, which contributes to financial uncertainty. Macro Uncertainty is highest just before inflection points, at which we believe we have just arrived. Accordingly, we believe that the most widely-anticipated and broadly-forecasted recession in recent memory may have just begun, or at the very least, could be just around the bend. Given that the global risks are clearly toward the downside, it would not surprise us to see continued weakness in risk assets during a period of the year when they typically rally.

*Private investments are valued less frequently and on an appraisal basis. This reduces the volatility of their returns and accordingly makes them appear superior on a risk-adjusted basis. To correct for this smoothing effect, this analysis therefore uses publicly-traded baskets of private instruments as a proxy of return and risk. All methods to make public and private investments comparable are flawed; in our opinion, this one is the least.

**Network effect, monopoly, momentum factor, and quality factor are among them.

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