If you spend a significant part of your day staring at your computer to watch the markets, you know that, perplexingly, the traditional safe havens for mitigating portfolio risk haven’t been working very well. For example, gold, which is supposed to go up when investors and traders sell stocks instead went down along with stocks during the late January to early February sell off. Treasury prices went up (and Treasury yields went down) on negative news about inflation, interest rates, and the U.S. dollar that should have sent them in exactly the opposite direction. On some days when volatility in much of the market was climbing and general market indexes were falling, the price of risky stocks–biotechnology shares, like those of Nektar Therapeutics (NKTR) for example, and very high PE technology shares, such as Amazon (AMZN)–climbed.
All this is anecdotal, of course.
But now Goldman Sachs has put its computers and data crunchers to work and has reached the same conclusion. “No safe havens–and no assets or equity sectors–have had a positive beta to the VIX [CBOE S&P 500 Volatility Index] recently, and few have had a positive beta to 10-year yields, leading to diversification desperation,” Goldman’s strategists wrote in a March 12 note.
Goldman offers a good run down of the reasons for this period of safe-haven failure–and many of these reasons are undoubtedly familiar to you. For example, there’s the core failure of bonds to provide a risk alternative to stocks in a period when central banks are ending their buying of government and other debt instruments in programs of quantitative easing, and when the U.S. government has gone on a debt-creation binge. And there are country-specific reasons that some havens aren’t providing much safety. Japan, for example, is mired in a real estate scandal that could bring down the government of Prime Minister Shinzo Abe. Add in the negative effects of tariff rattling by the Trump administration and its no wonder that the yen has been weaker than expected in a volatile global financial market.
But if I can add something from my own observations, part of the failure of traditional safe havens right now seems to be the result of the incredibly complex interrelationships between asset classes right now. One effect of that is to turn a safe haven into a risk sink and then back into a safe haven in a matter of a handful of trading sessions.
Take the performance of Treasury bonds recently. They started off selling down under the pressures of a huge increase in the U.S. deficit (and hence the immense need for the Treasury to sell new debt.) That downward trend in prices and upward trend in yield was exacerbated by the same bad news on inflation (the emergence of a potential increase in expectations of future inflation) and on interest rates (3-4 interest rate increases from the Fed instead of 2-3) that set stocks onto a downward slope. But then, as the slide in stocks gained momentum, the decline in Treasury prices stopped and then reversed. Investors and traders decided to overlook the long-term trends that virtually guarantee lower bond prices and higher yields in 2019 and began to buy Treasuries because of their likely continued role as short-term havens. When fear got high enough, I’d argue, traders and investors reverted to behavior that had worked in the past–even when there was good reason to think that the long-term picture had changed radically.
The reasons behind the decline in gold prices when global stock markets began to fall remain, as far as I’m concerned, elusive. Gold is regarded as a stable store of value and it usually advances when so-called risk assets (such as stocks) fall. But this time gold fell along with equity prices. I’ve heard explanations that range from selling of gold by investors who had seen the rise in gold coming (SPDR Gold Shares (GLD) climbed 12.8% in 2017) and were now taking profits to a drop in demand from price-sensitive buyers in India and China in reaction to that 2017 rally to selling because of a preference among traders and investors for hedges that paid some income. (For example, if you believed the policy announcements coming out of the European Central Bank, you might well have decided that buying German 10-year Bunds was preferable to buying gold as a safe haven.) The behavior of gold prices might also be related to forecasts of increased production from a few gold mining companies. A projected increase in supply–or even just fears of a projected increase in supply–might have sent prices downward. None of these explanations is totally satisfying to me.
What I’m left with is a risk environment that is actually somewhat more complex and harder to navigate than the one that Goldman describes. It’s not one where traditional safe haven asset classes have stopped working as safe havens for an undefined but possibly lengthy period. It is one where traditional safe haven asset classes go from working to not-working and then back to working again (or vice-versa) in relatively quick order. If you’re looking for a safe haven, bonds might work for a while and then not and then work again.
What the poor, over-stressed trader and investor seeking safety is left with is the task of managing safe haven decisions in multiple time frames.
For example, look at Treasury bonds. In the long-term, as the U.S. Treasury has to manage the sale of $1 trillion in new debt this year and more next year and the year after as the debt incurred to finance the Tax Cuts and Jobs Act comes home to roost on the supply and demand ledgers of global financial markets, it’s hard to imagine that Treasury prices won’t fall and that Treasury yields won’t rise. That doesn’t mean that Treasury prices will always fall in every month or quarter. And it certainly doesn’t rule out the likelihood of a counter-trend rally or two or three when the liquidity of the Treasury market makes this U.S. debt a desirable short-term safe haven.
That complexity does suggest managing this former safe haven as a short position for the longer-term (as I’ve done by adding a double-weighted position in the ProShares Short 7-10 Year Treasury ETF (TBX) to my Volatility Portfolio) and occasionally going long Treasuries as a trade when yields have risen too far, too fast (and prices have fallen too far too fast.) The complexity does, however, also raise the question of whether that kind of short-term trading vitiates the whole purpose of safe-haven positioning and opens your portfolio up to more volatility rather than less. I’d prefer, and it’s the way I’d suggest managing any traditional safe-haven asset now, to keep to the long-term trend (downward in Treasury prices) despite any short-term volatility with the possible option of adding to the long-term position on any short-term volatility.
An example of that today is gold. The SPDR Gold Shares ETF (GLD) fell another 0.66% today, March 15, and is now down 2.62% in the last month. The immediate reason for gold’s decline today is a comment from recently appointed White House economic advisor Larry Kudlow that he favors a strong dollar and that he would be a seller of gold here. That gave traders just enough cause to sell gold and make a few dollars (leveraged into more dollars) on the trade. But Kudlow’s preference for a stronger dollar (and belief in weaker gold prices) has just about as much long-term influence on the price of dollars or gold as my preference for arriving in a limo over a crowded subway has over how I get to work in the morning. (Hello, #1 train.) The long-term trends still support the purchase of gold as a safe haven from rising inflation, a sinking U.S. currency, and global instability. Again, as with Treasuries, this long-term trend doesn’t preclude short-term swings in gold and/or the dollar in the other direction. For example, I’d certainly expect the U.S. dollar to get stronger in the event of a global trade war since it is emerging market currencies that will get crushed if global trade breaks down. I’d guess at this point that the uncertainty and fear introduced by a global trade war would be enough to send gold prices up so gold is, at the moment and despite very recent weakness, a solid hedge against trade-war risk. The only question, to my mind, then is whether you want to buy more gold on the current weakness. My preference is to say Yes, and so I’ll be tweaking my allocation to gold in my Perfect 5 ETF Portfolio. (You can follow that portfolio on my subscription sites JugglingwithKnives.com and JubakAM.com.)
I think the current market leaves traders and investors with three big challenges on managing risk and finding safe havens in times of risk.
First, there’s the question about what to do about the rising risk in the general U.S. equity market. Clearly this market hasn’t broken down yet, but it is throwing off signs that all is not totally well. I think the appropriate reaction to that now is to manage the risk in your portfolio from individual stocks. Selling those that seem too risky for the potential reward (remembering that risky stocks with high potential reward still seem to be doing very well) will raise the cash position in your portfolio and I think that’s the appropriate stance right now. Note that I’ve said “raising cash” and not “going all cash.” We’re not there yet.
Second, there remains the continued question of what to do about the risk of a bond bear market if you’re an investor who needs income. If you don’t need income, I think the solution is simple–avoid fixed income vehicles. Anything with a fixed coupon is likely to suffer in price as interest rates rise. For investors who need income, however, in my opinion, there’s no single simple solution. Own bonds to maturity rather than owning bond funds. Substitute dividend-paying stocks where payouts can increase for fixed-payout instruments. Look for special situations where the odds of a dividend increase are relatively high. My recent addition of Bank of America (BAC) to my Dividend Portfolio is an example of that.
Third, what to do about emerging markets? I’ve seeing a steady flood of advice that says, Buy emerging markets; they’re cheaper than the U.S. market. That simple statement is true, but it ignores the current level of risk to emerging markets from possible geopolitical events. If the U.S. and China engage in a trade war, as damaging as that will be to U.S. stocks, it is likely, on the historical record, to be devastating to emerging market stocks. If U.S. interest rates move from a slow ramp upwards onto a trajectory that mirrors a rocket, then emerging markets will take a huge hit as money sloshes toward the higher interest rates in the United States and out of markets such as Brazil, India, and Turkey. It’s early yet to take extreme steps–such as going short emerging markets–but I’d certainly be thinking about a plan for reducing exposure to those markets if something geopolitically nasty hits the fan. And I’d be lightening up on the riskier pieces of my emerging markets exposure both in terms of individual companies and of countries such as India and Turkey that have balance of accounts problems requiring big infusions of overseas cash to make the books balance.
These last three items aren’t as helpful as I’d like to be. They’re more like a note to myself (and you) of subjects for research. I’ll certainly report on anything of interest that I find.
