How can I protect my portfolio from market volatility?

Stewart Edginton, Head of EMEA Managed Solutions

The first half of 2022 has been the worst start to a year for a balanced portfolio since the 2008 Global Financial Crisis (figure 1). Market cycles have a habit of surprising, which recent events highlight. The main cause this time around is inflation, which many of us have underestimated. With the benefit of hindsight, it’s easy to understand how geopolitical events have magnified the problem.

The only broad asset class that has risen this year is commodities, and energy in particular. The market had good reason to be underweight this theme – including COP 26 in November last year, which progressed the global effort to reduce the world’s carbon footprint. With the increasing popularity of ESG investing, the energy sector had been given a wide berth. Yet recent events have illustrated that the transition to new energy sources is likely to be difficult and protracted. As a result, the broad commodity complex is likely to remain on investor radars for some time.

Although stock market volatility has been particularly high this year, conservative investors have really felt the impact because of the losses within fixed income. As rates have risen, bonds have fallen in value. In addition, corporate bond spreads have widened because investors are demanding a higher yield as compensation for the additional risk.

The result is that core bonds¹ lost 9% over the first six months of 2022 and conservative portfolios typically have a higher allocation to fixed income. According to Morningstar, the median cautious US dollar strategy lost 11.2% in the first half ² of 2022.

Don’t fight the Fed

Uncertainty around geopolitics and oil prices remains high. Will inflation remain stubbornly elevated or can western central banks achieve their 2% targets? At times of uncertainty, it’s usually a good idea to focus on what we do know and then size investment exposures according to the probabilities assigned to different outcomes.

Risk asset valuations are clearly more reasonable today than at the start of the year following a significant derating in both equities and bonds. This positive correlation is why traditional multi-asset portfolios have not protected capital this year. As we saw in the Financial Crisis, valuations can keep falling and trying to time the bottom is a fruitless task – it’s something you only ever know after the event. But this isn’t the Financial Crisis. As of now, both corporate and personal balance sheets are in good shape compared with the past, and even with some sort of economic slowdown, job availability is high as supply chains are rebuilt. The present macroeconomic environment is very different from then.

An old investing adage is ‘Don’t fight the Fed’. Chairman Powell’s last testimony was clear – policymakers will target the reduction of inflation at the expense of growth. Over recent weeks, markets have begun to price this outcome (figure 2).

This messaging may have caused a regime shift and we expect a change in asset class leadership in the second half, with fixed income making a comeback. How do we have confidence in this forecast after such a painful first half and why can’t the asset class keep getting cheaper? Let’s take the 10-year Treasuries as an illustration of what’s happened this year (figure 3). For euro-based portfolios, we could substitute 10-year Bunds.

The yield began the year around 1.5% and subsequently rose to a peak close to 3.5% before moving back to around 3%. Some investors believe the rate should move to 4% or beyond. But keep in mind that the 10-year rate is effectively the average of base rates over that period. There is scope for base rates to reach those higher levels for a short period but recent market moves suggest this would be recessionary (just as the market indicated in the fourth quarter of 2018, when the Fed was last in tightening mode).

During recessions, rates tend to come down – the Fed would pivot and soften its stance. So choosing longer maturity bonds can protect you from this recessionary scenario. Indeed, a move back to a 2% level for 10-year Treasuries would result in positive double-digit returns.

We take confidence from the Fed’s estimate of ‘the neutral rate’. This is the equilibrium level of interest rates that allows the economy to progress at trend growth – neither expansionary nor contractionary. We can debate the right level for neutral but the Fed estimates it at 2.4%. With US 10-year Treasuries trading at 2.8%, the market is telling us these bonds have capital appreciation potential (bond values go up when yields come down). Aside from the absolute level of interest being more attractive, this level now gives the potential for portfolio protection from slowing growth. When the yield was at 1.5% at the start of the year, it was below the neutral rate and we know what happened. Now we are above the neutral rate, the potential for negative correlation has returned and that means multi-asset portfolios can begin to work again.

Protect portfolios and generate additional yield

How can we implement these views in portfolios? The starting point has to be a base case. We believe the Fed will achieve something close to a soft landing, but think the risks of tight policy causing a recession have risen towards 40–45%. Uncertainty and left-tail event risk is high. Given the case we have set out for fixed income, we believe core bonds look reasonable value in a soft-landing scenario (we estimate 10-year Treasuries will trade around 2.5% by the middle of next year). But growth surprising to the downside would see that rate moving lower, producing higher returns from core fixed income.

In the first half of this year, one of the only ways to protect portfolios in nominal terms was to hold cash. As the cycle progresses from high inflation to lower growth, investors seeking some protection can hold core fixed income because it can make capital gains when growth slows (especially after an interest rate hiking cycle). This allocation should also mean that a multi-asset portfolio can defend better through equity volatility than it did in the first half. Indeed, our Chief Investment Office team has been adding to quality duration as rates have been rising.

Just as the market was underweight energy exposure at the start of the year, it is now underweight core bonds, which can heighten the chance of returns surprising to the upside in a slowing growth scenario. Keep in mind that portfolios leaning too much towards an inflationary scenario are ‘fighting the Fed’.

¹ Source: Bloomberg Finance L.P. as of 6/30/22. 1 50/50 is 50% MSCI World / 50% US Agg portfolio rebalanced quarterly.

²  Source: MorningStar - GAP UCITS Peer Group Performance Quarterly as of 7/8/2022