COVID-19 has reminded investors of the importance of defensive positions within portfolios during times of stress. But are the ‘safe havens’ of the past still up to the task?

Something unexpected happened during the COVID-19 market meltdown in March. Market participants were left baffled as US Treasuries, usually the most reliable of defensive holdings, proved to be anything but.

Within a ten-day period in mid-March, yields on 30-year Treasury bonds rose significantly just as the S&P 500 Index fell by about 30 per cent. The price of Treasury futures became disconnected from the underlying bonds, while liquidity – especially in off-the-run securities – unravelled.

Sunil Krishnan, head of multi-asset funds at Aviva Investors, was among those concerned about how events were unfolding. “Investors typically lean on government bonds to provide insurance in terms of negative correlation with equities, but also potentially to rally sharply,” he says. “In this case, bonds didn’t quite deliver. And it’s not just the direction but also the magnitude of the move, which went quite hard the other way.”

A raft of explanations quickly followed, most of which focused on the deluge of forced sellers in the market, from emerging market central banks needing US dollars to defend their currencies to funds selling assets to meet redemptions, and investors unwinding highly leveraged strategies such as risk parity to meet margin calls.1

Investment banks now have significantly less capacity to act as market makers and warehouse assets

Matters were not helped by the fact that investment banks now have significantly less capacity to act as market makers and warehouse assets (a legacy of tougher post-financial crisis regulations). So, during times of acute market stress, such as we saw in March, this structural lack of liquidity can exacerbate price fluctuations. Investors needing to quickly raise cash were forced to sell what they can, including other traditional safe havens such as gold, which also declined during the same period.

This raises some existential questions about which safe havens can be relied upon to provide ballast to portfolios in future.

The limitations of 60/40

It is important to note that the breakdown in correlation between equities and bonds didn’t last long. Synchronised central bank actions, including large-scale asset purchasing programmes, helped normalise markets. However, the level of protection offered by bonds has been noticeably lower in this crisis compared to previous episodes, according to James McAlevey, head of rates at Aviva Investors. When equities previously dropped by 30 per cent, bonds rallied much more materially than they have this time around. This is a function of an already low-yielding environment and the weaker responsiveness of Treasuries to act as a risk diffuser.

The assumption that a balanced 60/40 equity versus bond portfolio will provide enough of a diversification buffer is being challenged

“Negative correlation [between bonds and equities] will probably stay, but it’s unlikely to deliver the positive return delivered historically. Interest rates are at the zero bound, so it’s difficult to see that there’s going to be another 100 basis points of protection [from yields falling] in your back pocket,” says McAlevey.

The weakening capacity of bonds to hedge equity risk has a material impact on asset allocation decisions. “The assumption that a balanced 60/40 equity versus bond portfolio will provide enough of a diversification buffer is increasingly being challenged,” says Mark Robertson, head of multi-strategy funds at Aviva Investors.

Although investors have been diversifying away from listed equities and bonds, particularly into private assets, equities still make up a large chunk of most institutional portfolios. To hedge this, investors often seek exposure to government bonds, using either physical bonds or swaps. The US Treasury market is the deepest, most liquid and transparent – therefore widely held – but investors also have turned to other nation’s government bonds, depending on their currency risk appetite. But with governments around the world ramping up spending in response to COVID-19, investors face an extra dimension of uncertainty as to whether that long-held strategy will continue to work (see Figure 1).

Figure 1: Fiscal response to the coronavirus as share of GDP
Fiscal response to the coronavirus as share of GDP
Source: Centre for Economic Policy Research, April 10, 2020

Diversifying safety

“There’s a reasonable argument that March was a blip – that bonds and equities will resume negative correlations because their economic sensitivities are natural opposites,” says Krishnan.  “But it would be naïve to assume forced portfolio liquidations won’t return to the detriment of both.  It’s just not that straightforward.”

Portfolio managers will need to look at alternative ways to manage risk

In effect, if the way correlations break down could vary according to the specific characteristics of a crisis, traditional safe haven assets may not be able to fulfil that function and portfolio managers will need to look at alternative ways to manage risk. This was a challenge well before COVID-19, but is becoming more pertinent as certain strategies have lost their safe haven characteristics, such as Japanese government bonds (JGBs).

In 2016, the Bank of Japan was the first among central banks to initiate yield curve control (YCC), which typically aims to peg a specific level at some point on the yield curve, essentially by buying any outstanding bond at a price consistent with the target yield. 

“Once the Bank of Japan effectively fixed the JGB curve, the reactivity of Japanese government bonds to risk-off events was effectively gone so it was no longer valid as a portfolio hedge,” Robertson says. “You saw that same sort of dynamic start to come through in German bunds with rates in negative territory. And now you can question whether that will be the next step for US Treasuries. Therefore, you need to start thinking about other options to protect portfolios.”

It’s not clear whether the Fed will follow Japan and Europe into negative territory, although in May the futures market was pricing in a cut to the policy rate below zero.2 Jerome Powell, the current Fed chairman, has consistently pushed back against such a move. However, former chairman Alan Greenspan claimed last year “it is only a matter of time” before the US will enter negative territory.3 If that happens, US Treasuries will likely lose even more of their appeal as a risk reduction tool.

The answer may not lie not in any one particular asset class

Increasingly, the answer may not lie not in any one particular asset class, but a combination of different strategies offering a target level of resilience that can change over time.

Gold, for example, may become more attractive. Historically, it has been shunned by some investors when interest rates are high because there is no yield available from holding gold. But as interest rates are at the zero bound for major economies, that differential has markedly decreased (see Figure 2).

“Our central scenario is central banks will continue to maintain interest rates at very low levels and negative in some cases, so the opportunity cost of holding gold is low,” explains Peter Fitzgerald, chief investment officer, multi-asset and macro at Aviva Investors. “In addition, there is increasing evidence of monetary financing, which should be positive for gold.”

Investors are mainly worried about deflation being a consequence of the COVID-19 crisis, driven by a recessionary outlook combined with expected lower prices for energy, property and other items. Longer-term, however, inflationary pressures may be rising due to a combination of factors including a global supply shock, which could increase the price of goods; escalating trade tension between China and the US; and unprecedented monetary and fiscal expansion. If investors are worried about inflation, gold or inflation-linked bonds may be more appropriate to protect portfolios than conventional bonds.

Figure 2: Gold vs. US Treasury yield
Gold vs. US Treasury yield
Source: Aviva Investors, Macrobond, data as of May 18, 2020

“Gold and other precious metals have historically acted as a store of value in times of uncertainty. If uncertainty rises, particularly due to fears around inflation or helicopter money, one could see a substantial rally in gold,” Fitzgerald adds. “In an environment where you get unfunded fiscal expansion, which acts to debase fiat currencies, inflation could ultimately be engineered in order to reduce debt.”

Dollar versus yen

As with many past crises, the dollar has been a source of stability in recent months. However, there is considerable uncertainty over the greenback’s medium- to long-term prospects due to the tension between the country’s large-scale fiscal policy response and monetary expansion. The willingness for the Fed to potentially implement YCC, for example, could undermine the outlook for the US dollar as a store of value in future market dislocations, Robertson says.

There may be upside for the yen should Japanese investors repatriate their assets

During previous risk-off periods, the Japanese yen has fared well versus the dollar, and may do so again. Japan has a huge domestic savings base, a sizable chunk of which is invested overseas, McAlevey explains. There may be upside for the yen versus the dollar should Japanese investors repatriate their assets back home during a period of risk aversion.

It hasn’t played out quite that way in recent months, although that is likely down to an asset allocation change by the world’s largest pension fund – Japan’s $1.5 trillion Government Pension Investment Fund (GPIF) – rather than any fundamental reason. In March, GPIF was in the middle of a move to invest more capital overseas, which on previous occasions has created a temporary headwind for yen versus the dollar.4

“If you want to use the yen as a risk-reducing strategy, then you have to watch the net capital flow positions of Japan versus the rest of the world,” says McAlevey.

A more reliable option has been to go long yen versus the Australian dollar, which has historically had a higher correlation to the MSCI World Index than other currencies. Such a strategy can be an effective hedge against equity market downturns, with the yen likely to move in the opposite direction in such a scenario.

“This has become a much more attractive risk-reducing strategy to carry in the portfolio as it still retains that negative correlation to global equity markets,” Robertson adds. “A lot of the work we have been doing is to say, ‘OK, what we really want when we look at our risk-reducing strategies is to make sure they have the biggest impact when we need them the most’.”

Volatility as an asset class

Patrick Bartholet, multi-strategy portfolio manager and derivatives trading specialist at Aviva Investors, believes being long volatility can help buffer portfolios against severe equity market crashes. While central bank actions have obfuscated the underlying fundamentals of equity markets and dampened volatility, there’s no guarantee that they will continue to work.

“Investors have this belief in the ability of the Fed to do everything right when something threatens the stability of markets. This is very dangerous,” Bartholet says. Referring to previous occasions when central bank policies failed, he pointed to ‘Black Wednesday’ in 1992, when George Soros ‘broke’ the Bank of England.

If Fed policies were to fail, the only thing that is going to rescue you is a long volatility strategy

“If Fed policies were to fail, the only thing that is going to rescue you is a long volatility strategy, because then equities may be down, Treasuries may be down, and the US dollar may be down all at the same time,” Bartholet says. “Long volatility is probably the closest thing you have to be able to benefit from liquidity when it’s most valuable. Why? Because if the market is stressed, people who are stressed are looking for a way out and they are willing to pay a lot for hedges. If you hold a long hedge position, you have liquidity.”

Liquidity in that environment also allows investors to take advantage of more buying opportunities. However, long volatility strategies can be costly, and investors have been reluctant to pay for what is essentially insurance against tail risks over a lengthy period. Implementation is also complex and may involve a wide range of instruments such as puts, straddles, variance swaps and volatility swaps. Each of the different combinations have varying costs and react differently in terms of magnitude to stressed situations, while timing implementation and size are also important.

In an environment where central banks are aggressively aiming to reduce volatility, other tail hedges can provide a less expensive alternative. “But if we do eventually enter into an environment in which central bank policies don’t work anymore, or at least don’t work as well, then there is a strong case for being long volatility,” Bartholet says. “At some point in time, you do need something that is perhaps more expensive but will work when everything else fails. It’s a last defence.”

It’s all relative

Flexibility is key when building resilience. “Understanding how strategies behave relative to one another in different market environments is critical,” says Andy Ford, senior investment director in the multi-strategy team at Aviva Investors. Having access to a broader range of defensive strategies, including relative value, currency and yield curve strategies, may offer viable, less correlated ways to protect portfolios against market dislocations.

One example of a relative value trade that has held up well recently involves overweighting companies with strong balance sheets versus the Russell 2000, an index of small-cap US companies. The dramatic hit to earnings that is now inevitable for large swathes of the equity market will be particularly destabilising for those companies with high leverage that comprise the Russell 2000 index relative to those with more financial discipline (see Figure 3).

Figure 3: Performance of Good Balance Sheet vs. Russell 2000 against Global Equities
Performance of Good Balance Sheet vs Russell 2000 against Global Equities
Source: Bloomberg, Aviva Investors, April 2020, rebased to 100 as of January 7, 2020. Note: Global equities performance is based on MSCI ACWI in local currency

Another strategy may involve identifying relative value between different equity indexes, Krishnan says. The COVID-19 crisis has unearthed larger differentiations between companies that have greater resilience in earnings and those that are struggling. “We prefer to own companies that we think can deliver profit outperformance through what's going to be an earnings recession for the market as a whole,” he adds. Today that means a more resilient market such as Switzerland, rather than more cyclical regions such as Japan.

COVID-19 has reminded investors that a shock can come from anywhere

COVID-19 will teach us many lessons over time. For now, it has reminded investors that a shock can come from anywhere. While predicting the source of each crisis is riddled with difficulty, ensuring your portfolio has protection and understanding how those assets will perform in times of stress is a critical advantage.

As the dynamics of the global economy and its supporting plumbing system evolve, it also makes sense to do the same with our understanding of how safe havens operate. Given the distinct possibility they may not work as they have done in the past, a little diversification between safe havens will not go amiss.

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