by Russ Koesterich, CFA, Blackrock
With stocks on a rollercoaster ride this year, Russ discusses the various potential hedges that could smooth the ride.
2019 is fast becoming a year of extremes. After the best start to the year in decades, U.S. equities experienced one of their worst Mays on record. While stocks have subsequently bounced, the damage to risky assets lingers.
[backc url='https://sendy.advisoranalyst.com/w/JYLmDqsFPB5F892UoC9DLyNw/g1892M8idNVuKzDuIVOSrnsQ/Ojy33NNShVjYmv763jkhZOnw']The Nasdaq Composite and Russell 2000 indexes flirted with correction territory, down 10%, while semiconductor stocks approached bear market territory, down 20%.
Given the sudden shifts in the market, investors are once again exploring how to best hedge equity risk.
The challenge is that not all hedges work in all circumstances. For example, what helps insulate a portfolio against higher inflation is not the same as what youād want to own if you were worried about a recession.
The good news today, to the extent there is any, is that investors know what theyāre trying to hedge: a trade-induced slowdown. And if a slowing economy is the proximate danger, history suggests three, fairly reliable portfolio hedges: duration, gold and the yen.
Lessons from history
My colleague Paul de Vassal examined S&P 500 drawdowns of 10% or more going back to the late 1990s. What he found was that the traditional ārisk-offā hedges generally worked, albeit to varying degrees.
The most obvious and traditional hedge ā U.S. Treasuries ā gained an average of about 2% when equity markets corrected. Investors can do better by buying longer-duration Treasuries, but obviously at the cost of more risk (see Chart 1). Outside of duration, two other classic hedges also performed in a similar manner. Both gold and the yen also gained about 2% when equity markets were faltering.
The gold results are consistent with what Iāve discussed in previous blogs: Gold works best when volatility is spiking. Since 1990, in months when volatility was rising gold beat the S&P 500 by an average of 30 basis points (bps, or 0.30%). When volatility really spikes, defined as a monthly advance of more than 20% in the VIX Index, gold beats the S&P 500 by 5% on average.
The third hedge, the yen, is the least obvious. Why would owning Japanās currency help insulate a portfolio? Part of the rationale lies in the yenās role in carry strategies, i.e. borrowing in a cheap currency to fund better yielding assets. Historically, these strategies tend to unwind when volatility rises, which means investors need to buy back yen. As a result, as with Treasuries, the yen has had a consistently negative correlation with stocks since the early 2000ās.
Bottom Line
The bottom line for investors is that in an environment in which softening growth is the big threat, there are hedges that have worked relatively well during the past 20 years. For investors looking to maintain equity exposure but also manage risk, a combination of these three should help insulate a portfolio if things turn more interesting.
Russ Koesterich, CFA, is Portfolio Manager for BlackRockās Global Allocation team and is a regular contributor to The Blog.
Investing involves risks, including possible loss of principal.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain āforward-lookingā information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
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