Finding safety after investment paradigm shift

Since last summer, and exacerbated after the US election results, we have experienced a striking shift in the market’s perception of growth and inflation risk.

Bond yields stopped falling and went in the opposite direction. Fears of a “secular stagnation” of growth were muted by a synchronised pick-up in economic activity.

Policies of “fiscal responsibility” are being replaced with stimulus, led by policy makers in Japan and the US. This “paradigm shift” implies either higher inflation or a faster pace of monetary tightening to come – or more likely, both.

This is a very different economic environment to what investors have experienced in the recent past. If it persists, it implies poor future returns on global bonds. But if so-called safety assets perform badly, where can investors find safety?

Last year, the term premium on global bonds turned markedly negative.

A popular disaster hedge is gold, could investors find safety here? Typically, we focus on starting valuations and fundamentals to understand an asset class’ capability to absorb bad news and its capacity to deliver good returns.

However, gold is an asset that doesn’t produce cash flows nor is it widely used in industrial processes.

As such, building an accurate estimate of its fundamental value is challenging. And, consequently, its price behaviour is mostly dependent on market psychology.

What’s more, physically owning gold involves storage costs. Intuitively, when real rates are declining, gold prices should increase because the opportunity cost of owning it falls.

But the opposite is true in a scenario of higher real interest rates. If we plot a chart between gold and real rates, there is a clear negative relationship. A regime of rising rates, then, is gold-unfriendly. 

Another safety candidate is cash. It is insulated from asset price falls and benefits from a rising rate environment. Yet it offers no carry today, which implies an opportunity cost, and provides no capital appreciation in a recession scenario. In market crashes, bonds outperform cash and provide better protection for our portfolios. 

Again, a valuation perspective can help. For bonds, the concept of the term premium is key. This is the pay-off implied by current pricing of the bond relative expected policy interest rates.

Last year, the term premium on global bonds turned markedly negative, meaning that we were being penalised, rather than rewarded, for taking duration risk.

Today, we find a slightly positive term premium; bond valuation is much more “knife-edged”. We are not too far from a point where the diversification characteristics of global bonds would look very interesting. After all, a meaningful term premium would be like a “positive expected return insurance policy”.

A final idea is to look outside of mainstream asset classes. Specifically, hedge fund strategies such as managed futures (trend-following) could be useful. They exhibit low volatility and correlation with the overall market and can help reduce drawdowns.

For example, in 2008 trend-following funds had positive returns. However, alternatives are not suited for all types of investors. Hedge funds have a steep fee structure which can play against investors’ future returns, especially in today’s world of low sustainable returns. 

As we can see, a potential improving cyclical growth and inflation environment has left investors faced with a new economic regime and looking for an asset class that mitigate downside risk. To us, valuation is key.

Cash is preferable when the term premium is deeply negative but now the case for owning cash is not straightforward. Investors need to be active in their asset allocation. When market pricing changes, we need to re-asses prospective returns against baseline and shock scenarios. 

‎Pierre Dongo Soria is multi-asset strategist at HSBC Global Asset Management