All Weather and Regime Shifts
This is more of a question for you macro guys. I've done a bit of research lately regarding the All-Weather type portfolio run by those like Ray Dalio who have seen impressive returns for a few decades now with few drawdowns and low volatility. I think the concept is fascinating (four quadrants based on risk) and has definitely proven itself over time.
Here is the link that breaks down the strategy in a very simple manner for those who are unfamiliar with how it works:
http://seekingalpha.com/article/878251-Bridgewater-s-all-weather-portfolio-vs-harry-browne-s-permanent-portfolio
The concept is very fascinating but before implementing and trading large amounts of money on it, it is important to be aware of the individual holdings and the risks involved with each (obviously).
I say this because of what we, players the market, will be experiencing in the coming years. What I mean is the increase in interest rates, clearly following the above model would lead to serious losses among the Nominal Bonds, TLT specifically. The model calls for a 25% holding based on risk, which could be argued reasonable or unreasonable, but that is not the point of this thread.
The point of this thread is to deal with what to do in the next year or two with this model regarding the Treasury holdings (TLT, etc). For the last 4-5 years this model has held up incredibly well, but long term treasuries have performed well also... This, we know, will change in the coming years. So the discussion at hand is, what to replace these holdings with? How about going long the bear long-term treasury ETF (TBF), and long the emerging markets sovereign debt ETF(s) (ie PCY); play the spread?
I'm asking this because EM sovereign debt plays, along with Treasury bonds, are what I know the least about. Does EM sovereign debt historically out-perform treasuries during times of increasing interest rates? How do you macro guys intend to profit off this arguably large shift in the domestic/global markets that is to come? My area of greatest knowledge is in domestic equities/commodities, so I am curious what you may argue as being the safest/smartest play when it comes to holding (or shorting) Nominal Bonds and playing EM Debt Spreads from 2014/2015 and beyond.
Looking for advice and any sort of discussion regarding these questions, thanks in advance.
How do you know that "this will change in the coming years"? How can you be certain that US isn't heading into a lengthy period of "Japanification"? As BW mentioned in one of their notes previously, if you held JGBs from 2000 onward w/a wee bit of leverage, your returns would have been something like 20% per annum (quoting figures off memory here).
As to EM debt, indeed, it's probably a better bet during a period of rising USD rates than USTs, all else being equal. However, given that this is EM, all else is hardly ever equal and there's a lot of variations. I don't think generalizations are particularly safe here.
Additionally, I have the feeling OP thinks All Weather is a standardized portfolio... Even though they have a model-based asset allocation, I'm sure there are considerable modifications year after year (top-down view), essentially based over the original high/low growth vs. inflation drivers idea.
I completely agree with you both and I do understand this is not a standardized portfolio by any means. As the author in the SA article notes, his breakdown of the portfolio is a fairly vast generalization of how it works. I guarantee BWs method for determining risk among these assets goes above and beyond your standard beta/volatility measurements most have used for reconstructing this type of portfolio. That isn't as much of a concern of mine as that gets into proprietary things that myself nor others on here would prefer to share i'm sure.
However, my bigger point in making this thread really pertains to sparking a discussion about dealing with the UST side of things (nominal bonds vs EM debt) the Falling Growth and Rising Inflation quadrants if you will. I'm not so worried about holding things like TLT right now, but in the event the FED does increase rates even slightly, long term treasury values will really take a hit (ie TLT). In such a case, do macro traders tend to short these types of holdings and go long EM debt or will they merely underweight UST and overweight EM debt? Or is my understanding of such a play way off? In the event the FED maintains low rates for the coming years ("Japanification") holding long term USTs should continue to pay off well I assume?
My main question really boils down to: how do macro guys intend to play such a shift? (That may or may not happen as soon as some think)
It's a very valid question and the answer is that I have no idea what people who run the All Weather fund would do. My personal approach to these things is to find enough trades in the fixed income space that will provide a good payout in case things improve sufficiently to allow the Fed to threaten some sort of tightening. One asset class that should work for this purpose is TIPS. So I imagine that, as time goes on and deleveraging in the US and globally runs its course, these portfolios will rotate out of nominal USTs into TIPS. Obviously, there are risks there as well, but it's a possibility.
If you have USD dominated EM debt and the Fed hikes US interest rates, you'll get crushed by the embedded Treasury portion of the USD-dominated debt. This concept is somewhat hard to explain but you can think of it like this: the Fed sets the "risk-free rate" for borrowing US Dollars. EM countries pay a premium on top of that. If the risk-free rate of borrowing dollars rises, though, the holders of USD denominated debt will see the net present value of their future cash flows decrease just the same. EM debt would only be spared this fate if it were not denominated in US dollars (ie., it were local currency debt).
This is correct. EM debt is tough to generalize about but it certainly looked frothy earlier in the year. Both the base rate and premiums looked expensive, I think Bolivia issued $400mm of paper with decent maturity for like 5-6% that was massively oversubscribed - this from a country that explicitly flouts the "imperialist" convention of property rights.
Historically, tightening USD liquidity is not good for EM asset classes of any sort (see Mexico in 1994, many places in 1998, 2008), paricularly places that run CA deficits. Whether or not a slight backup in rates qualifies as true tightening I leave to you to decide; however, I would be wary of owning USD denominated EM paper in a world where USD is strengthening - Michael Pettis is a good person to read for all the problems this capital structure creates.
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