In search of effective hedges against market risks

ASSET markets are swimming in red so far in 2022, except for commodities and selected Asian markets.

What is an investor to do? Cash may seem to be a haven, but it is most vulnerable to inflation, which may prove stickier than pundits initially expected. In addition, those who are sitting in cash grapple with the tricky question of when to re-enter markets.

First off, there are some broad principles strategists agree on: One, diversification in portfolios is resonant, now more than ever amid the stomach-churning volatility.  Two, you still need to take risks particularly for a long-term portfolio, but the key is to be selective.

It may be tempting to avoid bonds, for instance, but bonds still have a role in portfolios. In fact, value is finally emerging in the asset class which has suffered very low yields for decades. As for stocks, the technology sector is bearing the brunt of the carnage; the Nasdaq Composite Index has fallen 17 per cent to date (as at May). But strategists still point to equities as a hedge against inflation, particularly companies with pricing power.

Standard Chartered Bank chief investment officer Steve Brice notes: "The fact that we've already seen the worst performance over the past 10 years hints at the possibility that the rest of the year would see things improve.''

Citi says in its CIO Strategy Bulletin in April that the Fed's response to inflation is to be blamed for the reversal of fortune among bondholders. Still, there is a silver lining. "With recent valuation changes in bonds, we see an opportunity to build 'negative-correlation' assets back into portfolios. When bonds are expensive and stocks are too, and asset allocation between them provides fewer benefits. With bonds having repriced so massively, the asset allocation value of bonds has risen proportionately."

Rates of between 2.5 and 3 per cent on US government bonds in a period of slower growth look attractive, it said, and rates may trend lower in 2023.

UBS Global Wealth management regional CIO Kelvin Tay says the initial adjustment to an era of higher interest rates can be tough. "But over longer time periods, markets have tended to adjust, and bond investors in particular have benefited from the opportunity to reinvest at higher yields."

What assets stand a better chance to serve as hedges against the ongoing risk of inflation, higher interest rates, slower economic growth or even stagflation?

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·      Commodities producers

One obvious asset class is commodities, which to date have posted strong double-digit returns of over 30 per cent this year based on broad based commodity indexes. But the commodities futures market is typically not as investable for individuals. Mark Matthews, Bank Julius Baer head of research Asia Pacific, says: "For many reasons, the so-called futures are very difficult to profit from, and very ease to lose money in… They are highly volatile. That leaves us with one last path to hedge against inflation, which is to invest in companies that produce commodities. That’s a prudent thing to do, as even as inflation comes down, it won't go back to where it was before Covid. It will probably be around twice as high as before."

DBS Bank chief investment officer Hou Wey Fook expects oil, base metals and gold to outperform, due to chronic underinvestment in fossil fuel infrastructure, structurally strong demand for base metals like copper and silver which are used in the quest for energy transition, and of course gold is a classic inflation hedge.

He favours oil majors which are key beneficiaries of high oil prices. "In the current energy upcycle, sectoral earnings have risen to multi-year highs, while valuations remain undemanding. As their business models include both upstream and downstream activities, they are able to maintain a steady dividend policy. This is expected to translate to higher dividend payouts for investors as energy prices stay elevated."

Ken Peng, Citi Global Wealth head of investment strategy for Asia, favours stocks of companies in global natural resources  and oil-field servicing, and capex beneficiaries such as equipment makers and servicing. "Investments in domestic (non-Russian) capacity for energy, metals and agriculture are likely to remain strong for several years."

·      Equities and Reits

Evelyn Yeo, Pictet Wealth Management Asia head of Asia investments, says real assets are seen as optimal inflation hedges. "Even if we are wrong and disinflationary forces return, allocation to real assets could compensate for the relatively low nominal returns we expect for publicly listed bonds and equities over the next 10 years." Apart from Reits, real assets include real estate and private equity.

UBS' Tay says in equities, the key is to find attractively valued companies that can generate earnings and grow regardless of the economic environment, "which will likely be less tolerant of companies that cannot demonstrate a path to profitability in the near future". "Loss-making tech stocks are most vulnerable, whereas high-quality tech stocks with solid balance sheets and strong cashflows, buffeted by high growth rates are likely to weather this period of uncertainty far better."

·      Fixed income

While bond prices are inversely correlated with rising interest rates, it would be a mistake to dismiss this asset class altogether. Citi's Peng notes that long-term US Treasury notes and bonds have suffered a record drawdown of more than 30 per cent since 2020. "When equities have 20 per cent drawdowns, long-term Treasuries have very positive returns. This is both a buy-dip opportunity and the hedging instrument of our choice. Structured products that take advantage of rising rates and high volatility can also serve as a suitable hedge."

Pictet's Yeo points to private credit and inflation-linked bonds, which may play a greater role to optimize diversification in a strategic allocation. "With inflation we expect deeply negative real returns on cash and sovereign bonds over time."

SCB's Brice says investors often think of gold and real estate as the best hedges against inflation but equities may also serve as a long-term hedge. "And, having an allocation to floating rate debt – our preferred option is private credit – is a hedge against sharply higher interest rates."

On a broader note, Brice says it may help investors to think in terms of scenarios and to start with a "foundation allocation" diversified across liquid asset classes including equities, bonds and gold. "This allocation works most of the time; it has generated positive returns in 8 out of the past 10 years, including double-digit returns in the past 4 years."

He adds that for all the chatter about how a typical bond-equity portfolio has failed investors this year, "we believe it would be a mistake to project this too far into the future''. “Indeed, we believe it argues for more diversification than less, with the inclusion of private real estate and credit asset classes alongside more traditional liquid investments.''

A balanced portfolio still works, says Peng. "Such portfolios have not had a negative return over 5-year periods. The past decade of the equity bull market has pushed many to abandon this tested-and-true strategy. Investors should be going back to a balanced allocation."