The ‘investor revolt’ continues. According to Investment Company Institute, U.S. equity funds had outflows of $17.5 billion in August on top of the $28.58 billion in July. These are very serious numbers. Overall, investors have pulled $50.3 billion out of U.S. equity mutual funds in the past quarter. What is also staggering is that they also withdrew $46.18 billion from bond funds during the same period. Seems like Main Street is fed up with risk and wants to be rid of it. At RiXtrema, my colleagues and I have warned our clients about increasing risk levels since at least June of 2015, as have many other risk managers. So, at first look it seems like a sensible step for investors to take some risk off the table.

But what did investors do with that money? It appears that they shifted a significant amount to international stocks and money market funds! Investors put $30.7 billion into international stock funds and $56.6 billion into money market funds during the past quarter.

Diversify Internationally? Only If You Want To Suffer Twice

The move to international stocks was likely prompted by the concept of diversification. However, there is a significant problem of diversifying U.S. equity exposure with international or emerging market equity. I know many textbooks and websites will suggest this approach, but there is no evidence that such diversification works. The correlations rise significantly in the tail and any diversification benefit from international or emerging markets equity simply vanishes. It is extremely unlikely for U.S. stocks to have significant losses and, at the same time, to have international equity act as a diversifier of risk. The investors in both equity markets are very much intertwined and losses in one will quickly lead to losses in the other. The past two months certainly provided another bit of evidence in that regard. Contrary to what Modern Portfolio Theory suggests, diversification benefits of spreading your equity exposure are very limited, because equity markets have become more and more correlated over the past two decades. This is what Rick Bookstaber called “tightly coupled markets.” Tight coupling is an engineering term that describes an interconnected system where failure in one part is likely to cause failure in other parts. Sound familiar? Yes, these are today’s financial markets (e.g., subprime debt, Greece, China).

Argument #1 For Treasuries: They Are Great Risk Diversifiers.

Why did investors not put their money into Treasuries? Clearly, they went with money market funds because those are basically riskless cash equivalents. Treasuries do carry interest rate risk of course and investors need to keep that in mind. However, what many investors and advisors miss is that a Treasury bond is one of the very few truly diversifying investments that we have available— perhaps even the only one outside of cash. International equities cannot diversify because, under stress, they are highly correlated with equities in the U.S. Most corporate debt funds are not great diversifiers in tail events. For example, corporate spreads have shot up significantly in 2008, inflicting heavy losses on corporate debt, even investment grade. But Treasuries have a very stable negative correlation with equity markets of about -.35. That diversification does not disappear during stress.

Argument #2 For Treasuries: Supply And Demand.

There is always demand for Treasuries because many institutions, such as banks, pension plans and others, are legally required to hold them. They are widely used as collateral for financial operations. When some bonds mature, the institutions have to acquire new ones. Additionally, much of the Fed stimulus has taken place through the Treasury markets. The Fed was buying so many Treasuries that it actually caused shortages. How is it possible you ask, for a virtual piece of paper to be in short supply? Alas, it is possible when many investors are required to own them (and so have to buy or can’t sell them) and the Fed decides to buy some as well. In fact, here is a Bloomberg story from a few months ago with some details on how it’s possible to issue lots of new debt and still be short of the underlying instruments.

Argument #1 Against Treasuries: Low Rates And Limited Upside

It is true that rates are very low and the upside is limited if financial markets are relatively stable. But firstly, upside is not the main objective when investing in risk reducing instruments. The objective is protection and some minimum income. Secondly, the upside can become very significant if markets continue to experience increased volatility (which is likely in the absence of QE4). In the case of a financial crisis, the upside to Treasury bonds is not as limited as most people think. The U.S. and the rest of the developed world are facing tremendous deflationary pressures. This could put additional downward pressure on interest rates; in fact, they could even become negative. One Fed member (widely thought to be Narayana Kocherlakota) already forecast negative rates in the U.S. during the past Fed meeting. Janet Yellen herself did not preclude the possibility, saying recently that if: “We found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools, and [a negative rate] would be something that we would evaluate in that kind of context." Near zero or negative 5- or 10-year rates would make Treasury a very attractive instrument in terms of the upside. So, it is a great protection against deflation. Investors should realize that the Fed made it virtually impossible to get a reasonably safe, reasonable yield out there. By forcing investors to take on more and more risk to get yield, they have led investors into a large arena with a tiny exit door. At least the low yield of Treasuries comes with some serious risk protection.

Argument #2 Against Treasuries: Interest Rate Risk & Losses

It is true that if rates do rise, Treasuries could lose a significant amount of money. A 10-year duration fund would lose 10 percent if rates rose by 1 percent. But if medium- and long-term interest rates increase, this would likely come in two possible macroeconomic scenarios. One would be a strong recovery where demand for funds would be strong to fund development and expansion projects. This outcome is almost impossible in my view given the worldwide economic data, which suggest that most developed economies are near recession. The second outcome where rates rise would be a kind of inflationary liftoff, or inflationary boom. The Fed finally gets a 2, 4 or even higher inflation number. Certainly Treasuries will lose. But if portfolios still contain a reasonable amount of equities, those are definitely going to rise in such a scenario. So, the loss on Treasuries would be well compensated for. That is the nature of true diversification—it doesn’t just diversify the losses.

But if equities and Treasuries drop simultaneously, we enter ‘stagflation’, however unlikely given the activist central bankers around the world. It did happen in the 1970’s. But my answer would be that in such a scenario, losses on Treasuries would be the least of investors’ problems. Rising rates and simultaneously dropping equities may have been difficult in the 70’s. With today’s levels of U.S. debt and the interest payments it will cause amid shrinking revenues from stock market gains, it would be a fiscal catastrophe. For this reason, I do not think that the Fed would ever allow such a scenario even at the expense of unleashing significant inflation. And if the Fed cannot manage it and we do get stagflation, all of us will have bigger problems than losing 10 or 20 percent on a bond fund.

Bottom line: You should own some Treasuries for your clients. International stock and corporate debt (especially A rated or lower) are absolutely no substitute for the diversifying power of equities. Treasuries will provide solid preservation of capital and some yield in almost all economic scenarios. If they do lose, it will most likely happen when the equity portion of the portfolio is gaining significant value, at least nominally.
 

Daniel Satchkov is president of RiXtrema, a risk modeling and consulting firm, and creator of Advisor BioniX, the first risk-aware robo platform for advisors.