Joe Zidle: What Got Us Here Won’t Get Us There

By Joe Zidle and Joe Dowling May 24, 2023

The title of this Market Insights is a phrase that executive coaches popularized to emphasize the need for positive behavioral change to grow and achieve more. Crucial to these goals is first acknowledging and then adjusting to a new set of circumstances. I believe this sentiment also holds true for the investing world, especially today, given the prospect of a markedly different future.

Although the Federal Reserve (Fed) can cyclically tamp down inflation, it’s important for investors to understand that long-term issues of inadequate investment and shortages across the economy will hinder a return to the days of easy money, stability, and excess liquidity. The need for investors to understand that they can find opportunities in this environment is also important, but it requires them to implement new strategies.

Today’s underinvestment, tomorrow’s inflationary pressure As we wrote last summer, a significant factor in the current inflationary pressures is the long-standing underinvestment in crucial assets like housing, energy supplies, and public infrastructure in combination with an undersupply of labor. This underinvestment contributed to shortages that exacerbated inflation, to which the Fed responded by raising rates and shrinking its balance sheet.

Ironically, today’s higher rates perpetuate underinvestment in interest-rate sensitive sectors and exacerbate shortages and inflationary pressures on a more secular basis. We have already seen some signs of this effect in the “real economy” with slowing in everything from homebuilding to capital expenditures.

Evidence of underinvestment across sectors The US housing market, for example, faces a shortage of millions of units. Similarly, the energy supply has been constrained due to years of inadequate investment. The shift towards renewable energy and decarbonization further increases the need for critical minerals, shortages of which are expected to worsen in the coming years, also due to underinvestment. Meanwhile, the trend of ever-cheaper labor and inputs, enabled by globalization, has stalled out as firms seek to diversify supply chains and make them more resilient.

The upshot is that while the Fed can control inflation on a cyclical basis, doing so might result in inflation being structurally higher in the next cycle. In that scenario, the Fed wouldn’t have room to maneuver a return to extremely accommodative policies.

Don’t expect the last cycle I recently shared our view that the Fed is unlikely to pivot towards easier monetary policy in the near term. The market hasn’t embraced the idea of higher rates for longer and continues to price in a quick return to accommodative monetary policies, as in the last cycle. The market’s overlooking the potential for a higher trend level of inflation and shorter, more volatile economic cycles.

Turning the page In this new regime, I believe investors need to consider the changing market dynamics and reassess their strategies. Prioritizing profits over multiples and credit over duration is vital to navigating a liquidity drought. Here to discuss this regime and offer a potential solution is Joe Dowling, of Blackstone Alternative Asset Management (BAAM).

With data and analysis by Taylor Becker.

Regime Shift Calls for a New Playbook

by Joe Dowling, Global Head of Blackstone Alternative Asset Management

In BAAM, we aim to build resilient portfolios that seek to generate compelling returns across various market environments. Predicting the future is impossible, so building resilient portfolios requires us to be probability-based in our asset allocation and investment decisions. The shift from quantitative easing (QE) to quantitative tightening (QT) means less liquidity and more volatility. As a result, investors need a new investment playbook, and in our view, absolute return strategies have the potential to deliver strong returns and diversify portfolios in these conditions.

It’s a different market now For a decade, markets benefited from a favorable investment environment. Interest rates were low, inflation was low and well-anchored, and globalization enabled companies to access the lowest marginal cost for inputs. Multiples expanded, and, as a result, asset prices went up. Investors were rewarded for investing in companies that sacrificed present-day profitability to deliver long-term growth. A traditional US 60/40 portfolio annualized over 11% returns in the 10 years between 2012 and 2021.¹

But those days are over. Interest rates are high, inflation is high and unpredictable, and companies value resiliency over efficiency. In many respects, the market trends of the last 10 years reversed. The traditional strategies that worked so well in the previous environment are now exposed to an increasingly difficult investment framework. The same US 60/40 portfolio lost 16% in 2022, one of the worst returns on record for the strategy.

QT for longer Starting in June 2022, the Fed moved from quantitative easing to quantitative tightening. During the prior QE era, the Fed was a recurring and large-scale buyer of assets, including US Treasury bonds and mortgage-backed securities. This injected dollars into the economy and ballooned the Fed’s balance sheet from roughly $1 trillion in 2008 to $9 trillion by the end of 2021.

In the wake of higher inflation, the Fed is now removing dollars from the economy by shrinking its balance sheet, most recently by letting securities mature and naturally run off. The Fed set the monthly cap on reduction at $95 billion per month, consisting of a treasury cap of $60 billion per month and a mortgage cap of $35 billion per month. We estimate that it will take 2–4 years to get the central bank’s balance sheet down to an equilibrium size at this rate.²

Less liquidity creates more volatility The QE era had abnormally low volatility across asset classes, and increased liquidity suppressed market movements. In fact, equity volatility was 23% lower on average in the 10 years between 2012 and 2021 versus the prior 10 years between 2002 and 2011.³ Meanwhile, bond volatility was 38% lower on average for the same periods.⁴

QT is reversing this trend, as declining market liquidity amplifies market movements. In 2022, volatility across asset classes increased substantially, and it remains elevated in 2023. While volatility translates into increased investment risk, risk often creates opportunity. Many alternative investment strategies benefit from heightened market volatility and increased dispersion within and across asset classes.

Time to scrutinize portfolio construction A market regime shift like this one requires us to reflect on how we invest and build portfolios. This means asking and answering difficult questions, including these three.

1. Will multiple expansion continue to drive returns in this environment?

It is unlikely. US equities currently trade at 17x next year’s earnings, which is in line with the average multiple over the last roughly 30 years.⁵ High interest rates are a headwind to multiples, not a tailwind.

2. What will a portfolio return if equities are flat over the medium term?

Equities were the primary driver of strong returns over the past decade. In a US 60/40 portfolio, equities returned 16%+ annualized while bonds returned about 3%. This performance suggests that many portfolios that performed well in the previous environment were over-reliant on equities.

3. Does the portfolio have truly “diversifying” exposure?

Recent negative equity/bond correlation made it seem like traditional portfolios were diversified. However, bonds are not reliable diversifiers historically. Equity/bond correlation was positive in 62% of the last 50 calendar years, including 2022.⁶

Absolute return strategies aim to be truly uncorrelated Traditional strategies like the 60/40 are not balanced when equities and bonds are correlated. Adding absolute return seeks to provide more balance through differentiated sources of return. Based on our analysis, we believe a 60/30/10 portfolio that allocates 10% to absolute return strategies can help accomplish this goal.

Examples of absolute return include trading, quantitative, alternative credit, and macro strategies. Trading strategies provide liquidity to markets by buying and selling securities as an intermediary. As liquidity becomes scarce, intermediaries command higher returns. Quantitative strategies seek to capitalize on short-term movements in markets without taking a directional view on the long-term appreciation of assets. Alternative credit strategies aim to invest in debt opportunities that are structural and less correlated to the economic cycle. And macro strategies take long and short positions in macro markets, such as interest rates, to express relative value views.

Putting these strategies together, absolute return exposure seeks to generate consistent returns regardless of underlying market conditions. We believe that their consistency and uncorrelated nature can build resiliency in traditional portfolios that may be exposed in the current environment.

1. US 60/40 portfolio consists of 60% S&P 500 Total Return and 40% Bloomberg US Aggregate Bond Index Total Return, rebalanced monthly.
2. Assuming the Fed reduces the size of its balance sheet at $95 billion/month and using a range of $4 trillion–$6 trillion for the equilibrium balance sheet size.
3. Calculates average VIX Index level from 2012–2021 and compares it to average VIX Index level from 2002–2011.
4. Calculates average MOVE Index level from 2012–2021 and compares it to average MOVE Index level from 2002–2011.
5. Bloomberg, as of May 2023.
6. Bloomberg, as of January 2023. Equities represented by S&P 500 and bonds represented by Bloomberg Barclays US Treasury Total Return Index.​​​​

The views expressed in this commentary are the personal views of Joe Zidle, Joe Dowling and Taylor Becker and do not necessarily reflect the views of Blackstone Inc. (together with its affiliates, “Blackstone”). The views expressed reflect the current views of Joe Zidle, Joe Dowling and Taylor Becker as of the date hereof, and neither Joe Zidle, Joe Dowling, Taylor Becker, or Blackstone undertake any responsibility to advise you of any changes in the views expressed herein.

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