In a late cycle environment, most commentary tends to focus on the challenge of finding return opportunities with reasonable risk and reward characteristics. However, finding reliable defensive assets is equally challenging. Until now, traditional balanced strategies have performed well, especially those with structurally long duration bond exposure. Despite more complex hedging strategies being expensive and at times unreliable, conventional developed market bonds have continued to be inversely correlated with equities, thus smoothing the bumps in the road and providing a return in excess of cash. But this period may be coming to an end. For long periods in the past, bonds have been positively correlated with equities and the risk is that such a relationship re-asserts itself and that conventional approaches to diversification, no longer flattered by high nominal and real interest rates, cease being effective.
While the consensus view is that interest rate increases in the US are going to be gradual, and that few other countries are in a position to follow the US in normalising interest rates, there is a real sense that the rate cycle is beginning to turn. Should growth turn out to be stronger than what is popularly characterised as ‘secular stagnation,’ it would arguably not take much in the way of growth surprises to impact bond yields. Even at the current moderate rate of growth in the US, the run rate of job creation is consistent with a sharp uptick in wage inflation which we believe could easily eventuate in the not too distant future. Furthermore, even if the consensus view proves correct, at current yield levels the benefit of developed market bond exposure in periods of market stress could prove to be very modest compared to previous periods. This was very much the case in August when equity markets sold off sharply and the offset from long bond positions was not material.
So how should one address the challenge of diversification? It is probably time to adopt a rather more tailored approach since one size no longer fits all. If owning US government bonds doesn’t offer the protection it used to, then shorting duration might offer some defence. Given the widely held view on the likely course of US interest rates, put options on interest rate futures appear to be surprisingly attractively valued. There are also government bond markets, such as those of Korea, Australia and Canada, where the likely path of interest rates means that they provide more protection than US Treasuries, particularly at the shorter end where correlations to US long-term interest rates tend to be much lower. Certain currencies also offer attractive defensive potential.
In our opinion, the yen appears to be well supported by Japan’s creditor nation status and improving cyclical fundamentals which should help it perform like a traditional ‘risk off’ currency in periods of market stress. Back in 2007, it was one of a very few defensive assets that provided strong diversification benefits. By contrast, other defensive assets had been pushed to unattractive valuations by loose credit conditions, which is not dissimilar to the impact of the zero rate policies of today. Interestingly, the dollar’s defensive characteristics may be eroding.
Equity options appear neither cheap nor expensive at present and volatility can be expected to rise on a cyclical basis, however pricing can periodically be more benign. Despite volatility strategies appearing attractive, they have tended to be fraught with disappointment in practice because of high transaction costs and volatility that peaks but then rapidly subsides. Effective use of defensive exposures to diversify portfolios has to reflect changing valuation and cyclical contexts in exactly the same way as one should approach growth assets.
Philip Saunders y Michael Spinks are co-heads of Multi-Asset at Investec.
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