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Currency can protect portfolios where bonds can't

Bonds are traditionally used to provide downside protection during tough times for equity markets, however investors must be more flexible as economic momentum slows further

Currency can protect portfolios where bonds can't

Global growth has deteriorated, and financial conditions have tightened. This, coupled with political concerns, sparked a dramatic end to 2018 in equity markets.

The traditional approach to protect portfolios in adverse environments such as this is pairing stocks with bonds and relying on the negative correlation that typically exists between these two asset classes. In other words, when your stocks go down, your bonds go up, and you end up OK.

Bonds will often provide protection, but that will not always be the case. Another option is currency.

Looking beyond bonds

The first thing to consider when seeking to defend portfolios against a selloff in stocks is what is driving the selloff. And, specifically, whether that driving force is something that should support or undermine bonds.

Last February, stocks were selling off on concerns about higher inflation and higher interest rates, termed a negative monetary shock. This is a bad environment for bonds too.

If you protected your portfolio by adding bonds in February, the bonds would not have reduced risk. In fact, they would have actually increased it and exacerbated negative returns.

Back then, we shared the market’s concern about a negative monetary shock but, rather than protecting the portfolio using bonds, we used volatility. We expected the equity market to become more volatile, so we bought VIX futures, which is where predictions about volatility are traded to make money. This meant as stocks and bonds fell, we gained helpful diversification and downside protection from the surge in the VIX.   

Fast forward to today, the situation looks quite different. With global central banks broadly moving in a dovish direction, we do not see a negative monetary shock as the key risk to markets.

Instead, we are concerned about weakening growth data across the global economy, or what is described as a negative growth shock. When stocks are rattled by a negative growth shock, bonds tend to perform well and provide diversification.

However, while the current environment meets the first test of whether we should use bonds as diversification, there is another factor to consider: valuations.

Following the strong rally they have experienced over the past few months, government bonds now look expensive. US 10-year yields are close to 2.7%, and the market is already pricing in cuts in interest rates from the Federal Reserve for next year.

Eastern promise

So what about volatility? We expect volatility futures to provide diversification this year but, as with fixed income, this avenue now looks more expensive than a year ago.

That does not mean we are out of ideas for downside protection, though. In today’s markets, one option we do like is currency – in particular the Japanese yen.

The yen is a typical safe-haven currency, tending to perform well in risk-off environments. Japanese investors who have a lot of money invested overseas sell their foreign investments and repatriate their cash, strengthening the currency.

The yen appreciated in the fourth quarter, adding value for long investors, but it remains attractive on long-term valuation metrics such as purchasing power parity.

As we have moved further into the late stage of the business cycle over the past year, and therefore into an environment of rising uncertainty and volatility, it has become increasingly important to be flexible and to more carefully seek effective diversification to manage risks.

The market volatility experienced in the fourth quarter, and the subsequent rebound in January, highlight how quickly investor sentiment is shifting as the investment backdrop evolves.

Looking forward to the rest of 2019, we expect the decelerating economic momentum to translate into trend-like or below-trend growth for the year as a whole. Developed market central banks have limited scope to provide support at this stage.

Meanwhile, political uncertainty, most notably between the US and China, is elevated, which is taking a toll on business sentiment, investment and global trade.

Josh Berelowitz is portfolio manager at JP Morgan Asset Management's Global Macro Opportunities Team

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