Strategic Asset Allocation for an Inflationary Market Winter
Can oil provide shelter from the storm?
We are deep within an inflationary market winter, the likes of which we haven’t seen since the early 1980s. A market winter is an extended period of poor expected returns on the market portfolio. Since last September, when the inflation problem began to sink in, large-cap US equities are down 2.1%, while small-cap US stocks are down 11.8%. US Treasuries have provided no shelter from drawdowns — they’ve lost 11.7% of their market value. So, we are most definitely in an inflationary market winter — the most challenging macro environment for investors since the last time inflation was close to double digits some 40 years ago.
As usually happens during episodes of high and rising inflation, commodities offer some protection to investors. Indeed, over the same period, oil has generated stellar, if still volatile, returns. The most compelling bullish case for commodities can be found in the dispatches of Zoltan Pozsar. I am much more sympathetic to his picture than Adam Tooze. I believe that Zoltan is on point about the nature of the new macro regime, which given the state of Russo-Western relations, is virtually guaranteed to persist. So, I believe that there is a strong case for being bullish on commodities and bearish on all other risk assets.
How exactly can investors gain exposure to commodities and how should they determine the weights between the major asset classes? This is the classic question of strategic asset allocation.
First, which assets exactly? We can expect oil to perform well if the inflation situation deteriorates from here. Indeed, the cheapest way to hedge inflation risk is to gain exposure to an oil ETF. In what follows, we carry out a constrained mean-variance optimization exercise with three ETFs: SPY that tracks the S&P 500, AGG that tracks a broad basket of US investment grade bonds, and USO, an oil ETF. We impose constraints on the weights as follows. We allow equity allocation to vary between 40% and 80%, and we allow bond and oil allocation to vary between 10% and 30%. We robustly estimate expected returns and covariance matrices on a rolling basis using a 252-day window. Finally, we obtain tangency portfolios using standard mean-variance optimization. As always, we rebalance monthly.
During the present market winter, while daily returns on the SPY have averaged -1.9% per annum, the MVO portfolio has returned +9.1% per annum. If you think that the present inflationary market winter will persist for the foreseeable future, then this cross-asset portfolio offers some protection.
The portfolio has done well over the past year as well.
But as we go back in time, we begin to cover periods of stellar returns on the stock market portfolio. As a result, the MVO portfolio begins to underperform the market. Over the whole sample for which data is available, this amounts to losing about 3% per annum relative to the market portfolio. However, there is no underperformance relative to the market in risk-adjusted terms — they have identical Sharpe ratios equal to 0.56.
You can, of course, do much better by harvesting an intermediary signal and cleverly derisking your portfolio. But I can’t talk very openly about the product offerings of my firm — our outside general counsel would kill me. This, however, is pretty standard stuff, which I feel comfortable sharing publicly.
We’ve argued that we will quite likely be in an inflationary market winter for the foreseeable future. Under such adverse macro conditions, commodities offer some protection for investors. If you plan to switch to this portfolio, I suggest rebalancing monthly. The target weights for this month are 40% for SPY and 30% each for AGG and USO.
I feel a weight lifted. Been putting off rebalancing a while now but committed.