In October 2023, we highlighted the bullish market sentiment for bonds to illustrate the risk of using “muscle memory” as a forecasting tool. In the comments that follow, we'll link to earlier notes of ours to provide additional color. The ubiquitous 60/40 stock/bond allocation is widely considered a diversified portfolio: generations of investors are conditioned to expect rates to drop (bond prices to rise) when stocks are in trouble. So when stocks rolled over that Fall, many allocators heard the ‘all clear’ to load up on bonds again and run the play that worked so well in previous financial crises. Not so simple, as the chart shows: rates rose sharply at first and have zig-zagged ever since. Furthermore, rates have remained stubbornly high throughout the turmoil in the stock market this month. This should not come as a shock: in the longer arc of history, stock and bond prices have risen and fallen together more often than not. Forecasting is hard enough, but using the rear view mirror (or recency bias) as a crystal ball is folly. 

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10-Year Treasury Bond Yields:  

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If you know us you know our mantra: don’t try to predict what will happen; instead prepare for what could happen. As noted, this requires some understanding of the present. When our team grapples with the “big picture,” i.e., the larger forces at work, we need to consider the vastly larger number of moving pieces than are in play in financial markets. We approach these conversations with humility and ask you to take our conclusions with an appropriate grain of salt.

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Enough disclaimers. In Magnolia’s view, recent events reflect nothing less than an inter-related set of seismic shifts in finance and geo-politics that were already in motion, but are now proceeding at a breathtaking pace. 

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The US dollar’s role as the world’s reserve currency, a preference for “safe” assets, and the mercantilist policies of its trading partners have contributed to the widening imbalances we’ve witnessed. Many of the dollars Americans use to purchase foreign goods and services are recycled as foreign investments in Treasury bonds and notes, without which the US would have difficulty running large budget deficits. Demand for these assets drive demand for the dollar and make US exports less price-competitive with the rest of the world. And because the US tends to import more goods than services, this pattern of global trade has resulted in shuttered factories and the migration of economic activity away from traditional manufacturing centers. Higher returns to capital than to labor have further contributed to wealth inequality and together these forces have been a cause of social and political instability.  At the same time, America’s postwar role as guarantor of global security has made the US Navy the key piece of infrastructure supporting global commerce at its current scale. This is an expensive undertaking and its effectiveness far less assured with non-State adversaries engaging in asymmetric warfare. 

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Framed this way, the systems we know are unsustainable, and what we've seen in just the beginning of “de-globalization.” The US is relatively well-positioned to thrive in a new equilibrium: among major economies its economy is the least dependent on exports; its geography is blessed with abundant natural resources and the security of two oceans; it has deep and mature capital markets and a culture of risk-taking and innovation. Since other countries depend on the US consumer to buy their exports, the US has considerable latitude in rewriting the rules of the game…with one important caveat: the other side of the equation is the reliance on foreigners to fund massive fiscal deficits and the growing national debt. If and when a new equilibrium will be reached is unclear, and how we get there will be have broad secondary consequences. The price of US Treasury bonds, the “safe asset” against which all global assets are measured, lies at the heart of the uncertainty financial markets and the global economy now face. Muscle memory will be of no use in predicting its path this time. 

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Having indulged us to this point, you may well ask: what should I be doing about my investment portfolio today? This note should not be taken as investment advice, and we certainly hope you have confidence in your advisor; your personal circumstances, appetite for risk, future financial obligations, and long-term aspirations for your hard-earned wealth are the foundation of your investment strategy. However, we believe every investor can benefit from the principle of preparation and the application of this principle to owning a meaningfully-diversified portfolio. 

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Building a portfolio of diverse assets should be informed but not limited by observed market history. A portfolio should be resilient both to events similar to those that have occurred in the past, but also those that could occur in the future. The recent poor performance of both stocks and bonds warns us to look beyond the recent past for guidance, and to consider more reliable ways to protect an investment portfolio. Diversification means owning assets that perform differently in different environments: assets that don’t all go up in unison. If all the traffic lights are green one day, they’ll likely be red another. Some diversifying assets require greater diligence to understand and integrate into a portfolio (a key part of our jobs as advisors). Put another way, diversification isn’t quite the free lunch it's often called: it requires always being sorry about something. Unlike insurance, the purpose of meaningful diversification is to  reduce risk without impairing long-term returns. Owning a diversified portfolio requires patience but also flexibility. Indeed, some of the most effective  strategies adjust not to what we think will happen, but dynamically adapt to what is happening in the market. Managed with disciplined rebalancing, diversification helps us resist the urge to make the heroic market timing calls we usually regret. 

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We’re often warned to avoid saying “this time is different,” but sometimes the rules of the road change. When the facts change, we must be prepared to change our minds, at the same time admitting the limits of our vision. The principles and practice of diversification have not changed, and we will continue to seek out the best ways to protect our clients’ wealth. 

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Thank you for your time, and a special thank you to our clients for the confidence and the trust you place in us. We hope this window into our thinking about the world and about the principle of diversification provides context and comfort as we navigate these choppy waters together. We would be delighted to discuss these ideas with you further.

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