Short-term volatility remains likely, as policy makers in Europe – but also in the US – have a lot of fundamental problems to address. Markets remain sceptical that they will come up with the desired solutions and worry that politicians will remain behind the curve, says Willem Sels, UK Head of Investment Strategy, HSBC Private Bank…
This week could be crucial in this respect, as EU leaders are meeting to discuss a banking union and the potential for closer fiscal integration. In this volatile environment, where much depends on policy action, which could provide just as many positive as negative surprises, we remain invested, but focus on quality assets and diversification. How to achieve that diversification, however, is an important debate. We will argue below that safe haven bonds have 1) become less effective as a hedge against risk and 2) they have become very expensive.
1. Effective diversification
Effective diversification is difficult to achieve just within the equity market. Most equity markets have betas. A multi-asset approach to investing therefore remains important, in our view.
Safe haven bonds show a negative beta, which means that they tend to rally when equities sell off. But the beta has become less negative recently. For 10-year gilts, for example, the beta now stand at just -0.09, which means that when one tries to hedge a 1 million position in global stocks, one would need to put an 11 million position of gilts against this to be hedged. Over the past 5 years, one would have needed closer to ‘just’ 6 million to be completely hedged. Of course, investors do not want to take away all potential risks from portfolios, but this clearly shows that bonds have become less effective as a hedge. This is intuitive: given the very low yields, the potential for positive bond returns is getting ever more limited, even in a scenario where equity markets sell off sharply.
There are many other assets that provide good diversification potential, with betas near zero. Although investment grade (IG) credit has a positive beta, it is very low. This is a result of the inverse correlation between credit spreads and bond yields, which tends to temper the volatility of corporate bond yields, and hence the volatility of corporate bond returns.
Currencies are generally considered to be quite volatile, but what is sometimes overlooked is that some currencies show low correlations with the equity markets. Therefore, they can be valuable diversifiers. JPY and CNY positions should allow investors to diversify away equity risk (USD is not shown here as we quote currencies against USD, but should work well for a EUR or GBP-based investor). Even emerging market (EM) currencies have betas that are far from 1, as they not just driven by global risk appetite but also by local factors.
2. The cost of diversification
When we look for diversification, we would of course rather pick an asset that is cheap over one that is very expensive.
Gilts and Treasuries are the most expensive. This of course has an impact on IG creditvaluations: although spreads are attractive in our view, the very low government bond yields means that overall corporate bond yields are not very attractive either. This is why we like to add some high yield to credit portfolios, which offers some more value.
When looking for value, we come back to the currency market: EM currencies have sold off substantially in past months, and we believe that they could offer some good long-term value in portfolios, even if we foresee short-term volatility as a result of global uncertainties and concerns over the Chinese slowdown.
Commodities are an area we watch with some interest: oil and other commodities have sold off sharply in the past 12 months, but most commodities do not look that attractive on a 5-year history given strong appreciation in previous years. We maintain a neutral allocation on commodities for now.
3. Putting it all together: diversification strength and the cost of diversification
Simply put, most assets above the regression line can generally be considered less attractive than those below the line.
Unsurprisingly, we find Treasuries and gilts very much at the top end of the chart, supporting our conclusion that they are expensive, and not our preferred way to hedge portfolios. We also find many currencies below the line. Although EM currencies are certainly imperfect hedges for equity portfolios, their low valuations add to their attraction, in our view.
Equities are generally higher on the chart than commodities, arguing for some increased commodity exposure when risk appetite stabilises. Within equities, US and German valuations seem expensive relative to some EM valuations (and, of course, European valuations). If risk appetite stabilises in the coming months, this observation suggests that some increased exposure to EM stocks, and selective European
stocks makes sense.
What we have attempted to show is that gilts and Treasuries are not the only way to diversify a portfolio. They have lost some of their diversification potential and are very expensive, in our view. In addition, safe haven bonds could well sell off when risk appetite stabilises or the Eurozone progresses on a fiscal union plan.
We think credit and currencies can add to the diversification at a much lower cost. We have also shown that select EM and European stocks, as well as some increased commodity exposure may make sense once risk appetite stabilises.