Updated: May 18, 2022
My framework for thinking about asset allocation and thus portfolio protection is based around business cycle analysis. It is well documented that bonds, equities and other asset classes exhibit distinctive behaviour at different points of the cycle.
"As for safe haven assets, they may not be that safe any more"
For example, equities tend to perform poorly during the ‘peak’ phase of the cycle, when monetary policy has become tight and begins to impact growth and inflation. Bonds perform poorly during the ‘expansion’ phase when inflation and real interest rates are rising. And the worst time for commodities is during the ‘recession’ phase, when both growth and inflation are weak, possibly negative.
So, where are we at the moment?
Developed countries on average are close to the boundary between ‘recovery’ and ‘expansion’. The US began raising interest rates over a year and a half ago, in response to improving growth and inflation prospects. This improvement has continued, and it is likely after the recent lull that inflation will soon start to rise again. When taking other things into account such as the state of the labour market, I conclude that the US is now in its expansion phase.
The UK is not far behind, having also seen unemployment fall to low levels as well as the economy receiving a boost from sterling’s weakness. But wage pressures remain weak, and the Bank of England has yet to start to raise interest rates. Thus it seems fair to say that the UK is still in its ‘recovery’ phase, albeit near the end.
The Eurozone and Japan are further back still, with inflation pressures in both cases still very weak. It will be a while before respective central banks have good reason to increase interest rates.
In other words, we are still some way from the point at which equities start to perform poorly, which is another way of saying that the next bear market remains some way off. Equity market returns may ease off over the coming months, but they should stay positive.
In this environment, one should not take risk off the table, right?
One may like to think that one can wait until the end of the bull market to reduce equity risk substantially but one would be fooling oneself. For starters, it is always hard if not impossible to time. Secondly, making drastic changes quickly to portfolios is also impractical.
No. It is much better to gradually reduce equity risk as the bull market matures. Like driving a car, one should slow down as one approaches a bend, not when one reaches it.
So, although we think the next bear market is some way off, we started reducing our equity risk a year ago. We are now neutrally positioned, and will henceforth move more and more underweight over the coming couple of years. This helps to mitigate the effect of being early or late, which in investing is a certainty.
As for so-called safe haven assets, they may not be that safe any more. Bonds and arguably gold too are horrendously expensive, so may not represent the best form of insurance. In my opinion, a much better way to protect yourself is to improve your home security system. What I mean by this is to look for safety elsewhere, such as in the infrastructure space. There you’ll find government-backed revenues and tariffs that are linked either explicitly or implicitly to inflation. In other words, you’ll get both credit protection and inflation protection. You may get a bit more volatility, but at least you won’t get the permanent loss of capital on offer from safe haven assets.
Published in Money Observer
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.