Since the 1980s, a balanced portfolio has been a great alternative to a full – highly offensive – equity portfolio. A balanced portfolio typically consists of 50 percent stocks and 50 percent bonds, although the children of the bull market have gradually stretched the stock weight to 60 or even 70 percent.
At the time of a larger correction in the equity market, interest rates fell by an average of two per cent and, with a duration of five years, this meant a price gain for bonds of 10 per cent.
A simultaneous 20% fall in the share market compensated for much of that loss. On balance, the balanced portfolio fell by 5 per cent. Those days are over. At a time when the stock market is under pressure, interest rates do not budge.
There is even a great risk that rising interest rates will cause a correction in the stock market. Due to the extremely low interest rates, the duration has increased to 10 years, which means that if interest rates rise by 1 percent, there is a loss of 10 percent on the bond component and, of course, 20 percent on equities. At portfolio level, a loss of 15 per cent.
Chances are that the balanced investors did not accept this risk in advance. After all, risks are always estimated on the basis of historical developments, but again these are no guarantee for the future. That is when the real risk arises.
The moment the portfolio does something that was not expected, the need arises to take action. Often this means selling positions, but at the wrong time. This is when the real risk for the investor arises, namely the permanent loss of capital.
A crisis-proof portfolio
The holy grail in portfolio construction is now whether a portfolio with the same characteristics as the traditional balanced portfolio can be constructed with investments besides expensive bonds. It is not good enough that the value of that investment remains the same in a correction. The value must go up in order to compensate for losses on equities. One of the characteristics of financial stress is that different investments then correlate more strongly with each other. At the depths of the crisis, the correlation often goes to one. But one crisis is not like another. They can be roughly divided into two groups.
For example, a crisis can be a consequence of insufficient demand. Central banks and governments provide sufficient liquidity to solve this problem. A crisis of another type is caused by insufficient supply. Today, stock markets are at record levels, yet there is a shortage of semiconductors and various components. There is also a shortage of labour and a possible shortage of energy. The risk of a crisis next year seems rather to be caused by insufficient supply.
Risk is insufficient supply
When there is insufficient demand, the risk of rising inflation is not so high. More supply than demand is not a recipe for rising prices. In such a situation, bonds are normally ideal to protect the portfolio from too big a fall in stock market prices. But when demand exceeds supply, prices can only go one way and that is up. Inflation is rising and inflation is the great enemy of bonds. Some may see rising inflation as the biggest surprise of 2021, but the really big surprise is rising inflation combined with extremely low interest rates.
Central banks no longer dare to call inflation temporary, but the bond market firmly believes that inflation will fall hard next year. This is remarkable, because anyone can calculate that demand will increase further next year. With the latest virus variant being more contagious but milder, the global economy could open up further in 2022.
The coronavirus will remain with us, but thanks to vaccinations and increasing herd immunity, it will prove to be one of the ‘hazards of modern life’, just like the flu. After all, we live in large groups, the ideal environment for viruses. Now, in this context, shares like Moderna and Pfizer meet the requirement that they rise if a new virus causes the rest of the stock market to fall. Incidentally, certain tech companies also benefit from a new lockdown. They thus fulfil the same role as bonds did before, but for a very specific and decreasing risk.
Hedging inflation risk
A much bigger risk is that strong demand combined with limited supply will keep inflation high. Besides the opening up of the economy, there will be plenty of investment next year: in more capacity, in better supply chains, in the energy transition, in infrastructure or else in some kind of recovery plan. Now there are still inflation-linked bonds. They too look expensive and often have a high duration, so that if real interest rates rise, they often lose more than normal bonds. But compared to other bonds, they are not that expensive.
Long-term inflation expectations are not much higher than pre-Covid. This is partly because long-term interest rates are also kept artificially low. We call it inflation expectations, but it is nothing more than the interest rate difference between a normal bond and a comparable inflation-linked bond.
If there is no free price formation on the bond market, it does not make much sense to use this as a starting point for inflation expectations. It is more likely to lull central bankers to sleep. Fortunately, there are other investments that benefit from rising inflation and the investment case for commodities is improving. This year it is already the best asset class, but in a risk-off scenario next year that could easily continue.
For the most important commodity – oil – demand will outstrip supply next year for the first time in history. The combination of low oil prices and ESG concerns have resulted in a complete lack of investment in new capacity in recent years. A deal with Iran or the start-up of shale resources could help in the first half of next year, but after that it will stop.
Besides oil, metals are in demand, some because of the energy transition. In agricultural commodities, a second La Nina next year will bring similar weather as this year and that does not look good for the harvest. There is one commodity that could also be a big winner next year and that is CO2. European CO2 allowances have risen by about 150% this year, but that is still nowhere near enough to meet the Paris climate targets.
Expect much higher CO2 prices. In an inflationary scenario, there are also some investments to avoid. Beware of companies with many low-skilled employees. Energy-intensive companies can also get into trouble. At the same time, there are companies that benefit, such as those that make robotics. Also countries that are an alternative for the more expensive Chinese personnel are interesting. Think of Vietnam, Indonesia and Mexico. Incidentally, Japan is another country that has been striving for more inflation for years; perhaps it is now succeeding. In any case, it is not a country where the central bank will soon be forced to apply the brakes.
Protection against the risk of a sell-off
Apart from the inflation risk, it also feels good to protect the portfolio against unknown risks. After all, you always get bitten by the snake you can’t see. Often, this kind of risk is hedged by derivatives or going long on volatility. However, in the absence of a crisis, this comes at the expense of returns. The advantage of bonds in the past was that they provided a positive return in normal times and formed an extra buffer in the event of a crisis.
Yet such bonds still exist. These are Chinese government bonds, the second largest bond market in the world. Their effective yields are higher than inflation and there is also a structural appreciation of the renminbi, fuelled by the monetary madness in the West. China wants to position its currency as a reserve currency.
The great advantage of reserve currencies for investors is that they often rise in times of crisis. Many investors think they have to hedge the dollar risk, but by hedging the reserve currency they get two strikes in times of crisis. The stock market then falls in value while the dollar rises, but of course not if you have hedged it. The Japanese yen is also such a safe haven, if only because Mrs Watanabe converts her currency positions into yen in times of crisis.
There are also companies such as trading houses that benefit from rising volatility, but there are not that many of them. Currencies can fluctuate wildly in times of crisis, and the currency is the ultimate outlet for monetary madness. A good reason to avoid those currencies as much as possible.
New euro crisis
Speaking of the euro, there may be renewed speculation of a euro crisis next year. For example, when the populists in France, fuelled by rising inflation and sky-high energy prices, threaten to come to power. They are not exactly pro-euro. It is possible that there are better alternatives in the rest of the world, for example in Canada, Australia, New Zealand and the Scandinavian countries.
So it is possible to protect a portfolio against various risks, but never against every risk. Investors must accept risk, remember that risk is the reason why there can be more return than on a savings account. In any case, try to avoid selling at the bottom. Investments that benefit from a risk-off situation can help with this, but they must be part of the portfolio. Unfortunately, all too often investors say they have nothing against risk, until it costs them money.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear on Fondsnieuws in Dutch on Tuesdays and Thursdays and from time to time in English on Investment Officer Luxembourg.