SI424: Can Your Portfolio Survive the AI Hangover? ft. Alan Dunne

Alan Dunne · Archive Capital

Bond-equity correlation has turned positive this decade, driven by sticky inflation and supply shocks, making bonds a tough asset.

The bond-equity correlation was negative for decades (the 2000s and 2010s) and has been positive since 2020. In aggregate, inflation has been higher and stickier than in the prior decade, and there have been more adverse supply shocks (Ukraine, COVID, the Iran war, higher energy prices). That has made bonds have a tough decade. Within the period there were distinct sub-regimes, so the average correlation of about 0.3 masks a lot of variability. The forward question for allocation is how bonds and equities will behave, not what the historical correlation was.

“It was negative for for many decades... It's now shifted to positive since this decade. ... and all of that has contributed to that negative... Or sorry, that shift to positive in the bond equity correlation, which has meant that bonds have... Has had more... A tough decade, basically.”at 35:49

Alan Dunne · Archive Capital

Shifting to short duration gives up the duration kicker in a disinflationary equity sell-off.

There is a sense that investors should exit duration for short duration, which makes sense in the current environment. But every trade has a trade-off. In a scenario with a big equity sell-off that proves very disinflationary, duration would probably do very well. A portfolio that has moved into short duration would miss that kicker. The point is to allocate for multiple scenarios rather than make one bet on duration.

“If we were to go into the scenario... of a big equity sell off that ultimately was very disinflationary, duration would probably do very well then. And if you've moved into short duration, you're not gonna get that kicker from from the duration side.”at 42:18

Alan Dunne · Archive Capital

A fiscal dominance scenario could cap the fall in bond yields, favouring gold and trend-following.

In a fiscal dominance scenario, debt-sustainability concerns would cap or limit how far bond yields can fall, even if equities sell off hard. Debt concerns have crept into markets (2023, and to an extent recently), but they have not yet become a full-blown crisis in most markets, apart from the UK's 2022 Truss episode. Because yields would not fall much in that scenario, the case for allocations to gold or adaptive strategies such as trend following gets stronger.

“But equally, then if we go beyond that and into the fiscal dominance scenario that I'm talking about, that might cap the the the fall or or limit the fall in bond yields, and that would justify having allocations to assets like gold or also to adaptive strategies like like trend following.”at 42:36

Alan Dunne · Archive Capital

Arini's losses reveal systemic risk in high yield as its aggressive low-rated buying stops.

Arini Capital, a credit hedge fund that raised about $7.5bn quickly on strong returns, is reportedly down 22-25% this year. Dunne says the bigger issue is that it had been an aggressive buyer of lower-rated, lower-quality high yield names. With that bid stepping away, and several other credit managers also struggling, he sees the episode as a systemic concern for high yield and credit markets.

“this manager had been quite an aggressive buyer of maybe the lower rated, lower quality names. And with that bid stepping away, there are kinda more systemic concerns.”at 3:30

Alan Dunne · Archive Capital

ECB is reluctant to backstop French sovereign bonds, given France's deficit procedure and election risk.

European bond markets are under pressure, especially French bonds. Dunne notes the ECB has a facility to buy sovereign debt but tends to be reluctant to use it, particularly for France, which is in an EU excessive deficit procedure because its deficits are so large. He expects Lagarde's successor to be a political compromise, with possible commitments on supporting bond markets, and he flags the French presidential election with candidates proposing extreme ideas such as the ECB writing off bonds.

“they tend to be reluctant to do so, and particularly with... a country like France, which is going through the deficit procedure because their deficits are so large.”at 7:20

Alan Dunne · Archive Capital

Split government has historically been good for equities, but markets now fear a Democratic surge.

Dunne's understanding from history is that a split White House and Congress is generally seen as positive for equity markets. He is unsure of the exact data and says he would need to check. Yet he senses people are more pessimistic about the midterms, fearing a Democratic win would bring a more disruptive two years, pushback on Trump-era policies, and greater opposition to the AI and data center buildout, which are seen as risks.

“that kind of split, you know, government is generally seen as a positive for equity markets.”at 17:14

Alan Dunne · Archive Capital

Fed's 'new monetary medicine' framing overstates modest moves; credibility needs real action.

Under Chair Warsh, the Fed unchanged rates at the latest meeting with two dissenters and little forward guidance, and it cut meetings to fewer policy-focused ones. Warsh framed the approach as 'new monetary medicine' with five parts, but Dunne says the only actual move since May was a single 25bp adjustment, so the labeling oversells it. He argues talking tough about the 2% target only gets the Fed so far and that credibility requires action, so progress has been one step forward, one step back. Fewer but larger future moves could also mean more volatility around meetings.

“But I think that only gets you so far. And over time, action is required if you really wanna build credibility.”at 23:57

Alan Dunne · Archive Capital

AI capex boom could unwind; high debt and a high Buffett indicator make the downturn worse.

Dunne praises the Perkins report for showing the reflexive AI boom: capex boosts revenues and earnings, circular financing flows, and undepreciated spending inflating aggregate earnings. He thinks it could have pushed the reflexivity further and that the unwind may be less orderly and the wealth effect larger than the report assumes. With the Buffett indicator (market cap to GDP) at a high, each 10% fall in stocks would meaningfully hit consumption. Unlike 2000 or 1990, today's high debt levels mean an unwind-driven recession would push debt even higher, raising risks of fiscal dominance and financial repression. He says a hyperscaler capex cut is one plausible endpoint and that the boom could seed its own destruction.

“what you often find with boom bust scenarios is that the boom itself sows the seeds of its own destruction, and that could be the scenario here.”at 29:46

Alan Dunne · Archive Capital

Rising bond yields from competition for capital make neocloud business models less tenable.

Dunne says neocloud stocks and their higher-yielding bonds are already showing stress. Competition for capital from the AI buildout is pushing up bond yields, and those higher rates make the neoclouds' business models less tenable. He cites this as an early sign of how higher yields could curtail the AI boom.

“competition for capital is pushing up bond yields, and those higher rates are making some of those business models less tenable.”at 29:57

Alan Dunne · Archive Capital

An extreme oil price spike is an adverse supply shock that can hit bonds and equities together.

The scenarios that hurt both bonds and equities are typically adverse supply shocks. This happened in 2022, when rates rose after higher inflation, and to an extent in March of this year, when energy prices rose. So an extreme run-up in oil prices is one of the key risks to a 60/40 portfolio.

“We saw it with higher energy prices. So, obviously, a big, you know, an extreme run up in oil prices is one one one one thing.”at 46:40

Alan Dunne · Archive Capital

Precious metals still belong in portfolios as a diversifier despite near-term cyclical headwinds.

There is a case for precious metals. Cyclically, metals have faced headwinds in the last few months, and those may continue. But with financial repression and fiscal dominance concerns, precious metals remain part of the diversifying sleeve in portfolios. That is the reason to hold them even while their recent performance has been weak.

“Precious metals, I think there's a case for it. I think cyclically, obviously, there's headwinds to metals in the last few months that that may continue. But, you know, with financial repression, fiscal dominance concerns, I think they remain a part of the the diversifying sleeve in portfolios.”at 50:57