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Bridgewater Associates: Asset Class Returns in Deleveragings - April 2012
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Bridgewater Associates: Asset Class Returns in Deleveragings - April 2012


Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations may be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 Bridgewater ® Daily Observations 4/19/12 Bridgewater® Daily Observations April 19, 2012 ©2012 Bridgewater Associates, LP (203) 226-3030 Bob Prince Karen Karniol-Tambour Jason Rotenberg Lawrence Minicone Asset Class Returns in Deleveragings Because deleveragings don’t come along very often, most people don’t know how to navigate them. Since debtor developed countries are now in deleveragings, we think it is worth conveying how deleveragings typically affect the returns of asset classes. This is particularly relevant as we think about bonds. Many people believe that it is now virtually certain that bonds are a bad investment because bond yields are low, but this is worth reflecting on because in most deleveragings the return of bonds has actually been high. Below, we look at asset class returns in deleveragings and explore the reasons that bonds typically generate high returns through them. As we discussed in our recent Observations, “A Beautiful Deleveraging”, there are typically two phases to deleveragings – when money is very tight before there is big printing (e.g., 1930-1932 in the US) and when money is loose after there is big printing (e.g., 1933-1937 in the US). The differences between them depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) wealth transfer, and 4) debt monetization. Each of these four paths reduces debt/income ratios, but they have different effects on inflation and growth. Since asset returns are largely driven by how economic growth and inflation transpire in relation to what is discounted, the impact of deleveragings on asset returns depends on these combined effects. We call the first phase the “ugly deleveraging” phase. In it there are problems servicing debt. The associated fall-off in debt growth causes an economic contraction, creating a self-reinforcing downward spiral in which the debt/income ratios rise at the same time as economic activity and financial asset prices fall. In this ugly deflationary phase of deleveragings, the collapse in economic activity and asset values leads stocks to perform very poorly, while bonds leveraged to the same risk as stocks perform very well. Across a representative set of ugly deleveragings, the combination of weak growth and deflation caused equities to fall in all of these periods by an average of 23% per year. Bonds leveraged to the same risk as stocks gained in all of these periods by an average of 14% per year, much higher than the average bond yield during those periods of 3.7%.
  • 2. 2 Bridgewater ® Daily Observations 4/19/12 This ugly squeeze phase typically lasts a couple of years; its length depends on when policy makers print enough money to alleviate the short squeeze. When a sufficient amount is printed, deleveragings typically enter the second phase, in which debt/income ratios decline at the same time as economic activity and financial asset prices improve. This is what we are calling the “beautiful deleveraging” phase. It happens because there is enough “printing of money/debt monetization” to bring the nominal growth rate above the nominal interest rate, and typically there is a currency devaluation to offset the deflationary forces. In this beautiful phase of deleveragings, stocks and bonds perform roughly equally well in risk-matched terms as economic activity recovers while interest rates remain low. Stocks perform well in these beautiful deleveragings because the printing of money is sufficient to offset the collapse of credit and create nominal growth rates that are stronger than nominal interest rates. On average, across a representative sample of beautiful deleveragings, stocks returned 16% per year and bonds leveraged to the same expected risk as stocks returned 15% per year, even though the level of bond yields averaged only 3.4%. Ugly Deflationary Deleveragings US Depression Japan US Crisis Spain Average 1930-1932 1990 - Dec 2011 Jun 2008 - Feb 2009 Jun 2008 - Dec 2011 Inflation (8.7%) (0.5%) 1.7% 0.6% (1.7%) Real GDP Growth (8.3%) 1.0% (1.8%) (0.7%) (2.4%) Nominal GDP growth (17.0%) 0.5% (0.0%) (0.1%) (4.1%) Avg short rate 1.6% 1.3% 0.9% 1.4% 1.3% Avg bond yield 3.4% 2.6% 3.5% 5.1% 3.7% Total Return (Annualized) Equities (27.0%) (4.7%) (46.4%) (7.6%) (21.4%) Bonds 3.5% 4.8% 8.3% 4.3% / 8.2%* 5.2% Risk-matched Excess Rtn (ann) Equities (28.5%) (6.0%) (47.3%) (9.3%) (22.8%) Bonds 10.7% 12.8% 23.8% 7.4% / 39.8%* 13.6%* FX vs. Price of Gold (Annualized) 0.0% (3.5%) (2.1%) (20.2%) (6.5%) * Spain cannot print its own currency, so its bonds include the credit spread to account for its probability of default The returns shown on left are for Spanish bonds including the credit spread; those on the right exclude the credit spread The average of deflationary depressions uses the overall return of Spanish bonds including the credit spread.
  • 3. 3 Bridgewater ® Daily Observations 4/19/12 Throughout these types of deleveragings, duration-leveraged bonds generated high returns despite low bond yields because they benefit from a combination of a) falling discounted inflation in the deflationary deleveragings, and b) a steep yield curve and sustained zero short-term interest rates in both types. That is counterintuitive because it seems inconceivable that bonds can provide a good return when interest rates are so low because they don’t offer much yield and have a lot of price risk. The necessary degree of money printing that is sufficient to produce an orderly decline in debt-to- income ratios creates sufficient liquidity to hold interest rates below nominal growth rates and hold short-term interest rates near zero and well below bond yields. This perpetually steep yield curve reflects a continuous discounting of a rise in short-term and long-term interest rates, but interest rates do not rise as they were discounted to because the monetary policy necessary to produce the controlled decline in debt-to-income ratios keeps interest rates low. This continued steepness in the yield curve with sustained low interest rates produces high bond returns despite low absolute yields, because when interest rates rise less than discounted, yields “roll down the curve” and produce capital gains which are magnified through a moderate degree of leverage. The high level of debt combined with the inability to cut interest rates below zero handicaps the central bank’s ability to stimulate a normal credit expansion and a related normalization of interest rates in relation to nominal growth rates, requiring ongoing monetary support which holds short rates near zero for many years. This is how duration-leveraged bonds produced roughly 15% per year gains during beautiful deleveragings even though the level of bond yields only averaged 3.4%. The charts below show the short rate and the long rate on the left, and the return of bonds leveraged to the same risk level as stocks on the right, for each of the beautiful deleveraging scenarios. Beautiful Deleveragings US Reflation UK US Recovery Average 1933 - 1937 1947 - 1959 Mar 2009 - Present Inflation 2.0% 4.2% 1.3% 2.5% Real GDP Growth 7.1% 2.8% 0.7% 3.6% Nominal GDP growth 9.2% 7.0% 2.1% 6.1% Avg short rate 0.3% 2.5% 0.1% 1.0% Avg bond yield 2.9% 4.2% 3.1% 3.4% Total Return (Annualized) Equities 14.1% 13.3% 23.4% 16.9% Bonds 4.1% 3.4% 5.3% 4.3% Risk-matched Excess Rtn (ann) Equities 13.8% 10.8% 23.3% 16.0% Bonds 23.9% 4.7% 16.6% 15.1% FX vs. Price of Gold (Annualized) (10.0%) (1.4%) (18.9%) (10.1%)
  • 4. 4 Bridgewater ® Daily Observations 4/19/12 It takes an awful lot of printing to convert the naturally deflationary forces of a deleveraging into a highly inflationary deleveraging. It rarely happens, but when it does, it happens in a classic manner that is worth noting. In all deleveragings (both deflationary and inflationary) the average maturity of debt is shortened as the risks of either default or inflation rise. As buyers of bonds have less demand for them, central banks lengthen the maturities of their purchases, increasing debt monetization. At first that is beneficial, though it is a modest negative for the currency. If taken too far so that it is out of balance with the deflationary forces of austerity and debt restructuring, it will drive lenders out of the currency and out of longer-duration bonds, which will require the central bank to tighten to stem that flow. This is when bond vigilantes are in control and the central bank has little or no maneuverability. You can tell when that phase occurs because the yield curve steepens with long rates rising. The collapse of the currency pushes inflation, nominal growth and interest rates up, and the currency down, in a self-reinforcing spiral. Bonds and stocks perform terribly in this ugly inflationary environment, particularly in real terms, because the currency in which their cash flows are 0% 1% 2% 3% 4% 32 33 33 34 34 35 35 36 36 37 37 US Reflation Short Rate US Reflation Long Rate Steep yield curve 0% 50% 100% 150% 200% 32 33 33 34 34 35 35 36 36 37 37 US Reflation Levered B onds TR 24% Annual Total Return 0% 1% 2% 3% 4% 5% 6% 7% 47 48 49 50 51 52 53 54 55 56 57 58 59 UK Short Rate UK Long Rate Steep yield curve 0% 50% 100% 150% 47 48 49 50 51 52 53 54 55 56 57 58 59 UK Levered B onds TR 7% Annual Total Return 0% 1% 2% 3% 4% 09 10 11 US Recovery Short Rate US Recovery Long Rate Steep yield curve -10% 0% 10% 20% 30% 40% 50% 60% 09 10 11 US Recovery Levered B onds TR 17% Annual Total Return
  • 5. 5 Bridgewater ® Daily Observations 4/19/12 denominated collapses and inflation rises more than discounted. The collapse in the currency produces high returns in storeholds of wealth like gold, which rise in value in local currency terms, reflecting the decline of the value of the currency in gold terms. Please refer to our study on the Weimar Republic’s inflationary depression for a deeper discussion of these dynamics (let us know if you would like us to send you a copy). It is notable that gold also performs well in other types of deleveragings (shown in the chart below left). In ugly deflationary deleveragings, gold rises in value, but less, as expectations of money printing emerge and it is among the last assets to be sold to raise cash given its potential as a storehold of wealth. Gold tends to rise more into and through the beautiful deleveragings as the deflationary forces are neutralized and the more aggressive printing of money raises the supply of paper currency faster than the supply of gold. Through our sample of deleveragings, gold rose by 10% per year in the beautiful ones and 6.5% per year in the ugly deflationary ones. The chart below left shows the returns in the first two years of these episodes, when the differences are even bigger. In ugly inflationary deleveragings the return of gold is of course much more dramatic. The Weimar Republic is used in the chart on the right below as an example of an ugly inflationary deleveraging. The Reichsbank increased the money supply by 1.2 trillion percent between 1919 and 1923 and gold returned over 3000% in Reichsmark terms. Additionally, while all commodities serve as a contra-currency, or storehold of wealth vis-à-vis paper currency, each commodity will be affected in different proportions by the inflationary forces of money printing relative to shifts in supply and demand which are due to changes in economic growth. For example, economic growth impacts commodities that are used for production, such as oil, more than it impacts gold. As shown below, oil prices have generally risen during beautiful deleveragings, supported by both money printing and rising economic growth, and fallen in ugly deleveragings, when the contraction in economic growth overwhelmed oil’s value as a storehold of wealth. Cumulative Return of Gold in Deleveragings -10% 0% 10% 20% 30% 40% 50% 60% 70% 1 3 5 7 9 11 13 15 17 19 21 23 25 Ugly Deleveragings Beautiful Deleveragings Gold Cum Return in Deleveragings (ln) -100% 400% 900% 1400% 1900% 2400% 2900% 3400% 0 15 30 45 60 75 90 105 120 Ugly Deflationary Deleveragings Beautiful Deleveragings Ugly Inflationary Deleveragings Cumulative Return of Oil in Deleveragings -60% -40% -20% 0% 20% 40% 60% 80% 1 3 5 7 9 11 13 15 17 19 21 23 25 Ugly Deleveragings Beautiful Deleveragings
  • 6. 6 Bridgewater ® Daily Observations 4/19/12 Deleveragings typically come in waves of “beautiful” and “ugly” phases as central bank policies and economic conditions undulate in an intertwined manner. Through the various stages and types of deleveragings, while asset class returns fluctuate a lot, they always behave as one would expect given their structural biases to economic growth and inflation. The returns, volatilities and correlations of asset classes are unpredictable and extreme, but because the returns of assets are still driven by how economic conditions transpire in relation to what is discounted, the risk of a portfolio can be well managed by balancing its exposure to the forces of economic growth and inflation on asset class returns, which is our All Weather strategic asset allocation mix.
  • 7. Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research utilizes data and information from public, private and internal sources. External sources include International Energy Agency, International Monetary Fund, National Bureau of Economic Research, Organisation for Economic Co-operation and Development, United Nations, US Department of Commerce, World Bureau of Metal Statistics as well as information companies such as BBA Libor Limited, Bloomberg Finance L.P., CEIC Data Company Ltd., Consensus Economics Inc., Credit Market Analysis Ltd., Ecoanalitica, Emerging Portfolio Fund Research, Inc., Global Financial Data, Inc., Global Trade Information Services, Inc., Markit Economics Limited, Mergent, Inc., Moody’s Analytics, Inc., MSCI, RealtyTrac, Inc., RP Data Ltd., SNL Financial LC, Standard and Poor’s, Thomson Reuters, TrimTabs Investment Research, Inc. and Wood Mackenzie Limited. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.