Hedges in a bull market
It is hard to find an equity market anywhere that is not in bull market territory. This much is clear from a quick look at the Gavekal TrackMacro grid. Simply put, not a single country is now flashing red. You have to go back to the Spring of 2014 for such a benign global macro backdrop.
This isn’t to say that equity markets face no risks. Last week’s election result in the Netherlands may suggest that the populist wave in Europe is waning, but political risk remains high. In the US, policymaking is increasingly haphazard. In China, while stability will undoubtedly be maintained in the lead-up to the Party Congress this fall, it remains unclear what type of leader Xi Jinping aims to be, and for how long? This last point especially matters given Pyongyang’s bellicosity.
And that’s before the potential for a chaotic French parliamentary election is considered, as the historic parties of government (Les Republicains and the Socialist Party) both seem to be imploding. Or the fact that the mess in Italian banks is unlikely to be dealt with by a government with little popular backing.
Yet bull markets famously climb a “wall of worry”. The fact that equities are trending higher despite so many worries can be explained variously: (i) the fact that, in recent years, central banks have created so much liquidity, (ii) the growing realisation that under a mercantilist US president a US dollar short-squeeze may not unfold, or (iii) recognition that instead of imploding, Chinese growth is busy reaccelerating.
It almost doesn’t matter for, as popular wisdom states, success has many fathers. Still, as global equity markets continue to make new highs, the prudent investor is left wondering how to hedge? For years, the simple answer has been to buy long-dated bonds. As equities tank, bonds always thrive; looking back at every -15% or more annual drop in the S&P 500 since 1962 shows a corresponding 10% or more rise in bond prices.
This characteristic of bonds is the bedrock of most “risk-parity funds” and the reason why disciplined balanced funds have, over long periods, delivered solid risk-adjusted returns. At least, until the past year when the prevalence of very low bond yields almost everywhere caused bonds to hit many portfolios with more volatility and negative returns. This begs the question of whether bonds remain the most efficient portfolio diversifier.
As such, consider the chart below which in recent years shows a surprisingly strong correlation between gold miners and long-dated bonds. Historically, these two assets have tended to move in opposite directions, with accelerating inflation being good for gold, and bad for bonds, and vice versa. Now, they seem to be moving together, based on market perception of what the Federal Reserve will do next.
Take last Wednesday’s trading action: the Fed came out sounding marginally more dovish than anticipated, bonds, stocks and bullion was quickly bid higher. In particular, the Philadelphia Gold and Silver index (XAU) surged 7.4%. Which brings us back to the risks lurking in this bull market’s shadows and the best hedges on offer.
The first risk has to be that higher inflation proves to be more than a dead-cat bounce as prices grind higher on central bank willingness to stay behind the curve, while government purse strings stay wide open (Trump in the US, May in the UK, Abe in Japan, possibly Schulz in Germany). In such an environment, there may, of course, be no need for an equity portfolio hedge; at least for a while. Instead, investors would look to own “price monetiser” companies, along with markets whose valuations have been decimated by deflation (Japan, Italy, Spain, Greece). In such an environment, gold miners seem sure to outperform bonds.
The second risk has to be that equity markets are leaning too far over their skis, and instead of rebounding, growth, in the near term, disappoints (whether due to slowing bank loans, or reduced capital spending given fiscal and regulatory uncertainty). But if this scenario were to occur, how would the Fed react? Most likely by sounding dovish and, as last Wednesday’s trading action showed, any dovishness lights a fire under gold mining stocks even more than it does bonds. In fact, given their respective volatilities, a portfolio can perhaps be protected against a dovish Fed by holding gold miner stocks at just a quarter the level of long dated bonds.
The third risk is that growth implodes and equity markets re-adjust to a much lower structural growth environment in which the myth of the Fed as “price keeper” of last resort is finally put to rest. However, as last Wednesday’s markets showed, we seem to be far from such a realisation. Instead, the belief remains that of an omnipotent US central bank.
This isn’t to say that the somewhat unnatural correlation between long-dated treasuries and gold miners is some new permanent feature. However, so long as the Fed leans on the dovish side, and equity investors assume that the central bank is fighting their corner, the correlation between these two assets will likely remain. And from a portfolio construction perspective, this means that investors can hedge a dovish Fed with a modest amount of capital tied up in gold miners, as opposed to a pile of long-dated treasuries, or even puts on the US dollar.