21 May 2019
Michael Bell, Global Markets Insights Strategy Team
This is close to being the longest economic expansion on record. Nobody knows exactly when it will end, so it’s worth considering what investments could rise in value when equities and other risk assets fall during the next downturn. By including some hedges, investors can create a more balanced portfolio and help reduce overall portfolio losses when the next economic downturn eventually arrives.
Traditionally, investors turn to government bonds to balance the riskier assets in a portfolio. However, government bond yields in the UK are very low by historical standards. Having barely raised interest rates since the financial crisis, the Bank of England (BoE) has very limited room to cut interest rates.
Furthermore, the current political landscape complicates the outlook for UK government bonds (Gilts). In the event of a relatively soft Brexit deal being reached, the BoE would be likely to raise interest rates at a faster pace than is currently priced into Gilts. Failure to agree a deal could potentially require an election to resolve the Brexit impasse. While the outcome of an election would be hard to call, the prospect of a change in government could change the outlook for public spending and in turn put upward pressure on UK borrowing costs.
Investors may therefore want to consider government bonds outside of the UK, particularly in markets where the central bank has more room to cut interest rates during a downturn. Having raised rates by more than the BoE, the US Federal Reserve (Fed) has more room to cut interest rates during the next downturn.
Treasury yields have more room to fall than gilts
EXHIBIT 1: US AND UK 10-YEAR GOVERNMENT BOND YIELDS
% yield
Source: Refinitiv Datastream, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
If the Fed cuts interest rates back close to zero and global central banks restart quantitative easing during the next downturn, 10- year Treasury yields could fall back close to the lows they reached in 2012 and 2016. A fall to the post-crisis low of 1.4% over the next year would generate a total return of about 11% - lower than the returns provided by Treasuries in past equity bear markets, when the Fed had the ability to cut rates by more, but still a welcome gain in the context of a recession and the associated downturn in risk assets.
But what about the currency risk? With all the uncertainty around Brexit, the direction of the pound against the dollar is hard to predict. During the last recession, sterling fell against the dollar, but recessions haven’t always led to sterling weakness and the pound has already fallen a long way against the dollar.
Sterling doesn’t always fall against the dollar during recessions
EXHIBIT 2: GBP TO USD EXCHANGE RATE
US dollars per GBP
Source: Refinitiv Datastream, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 30 April 2019.
Given the uncertainty about the currency outlook, investors looking to buy Treasuries as a hedge for their equity risk may also wish to consider hedging out the currency risk - or at least reducing it to a level that reflects their degree of conviction in the direction of the pound. Currency risk relative to benchmark should also be considered if running a relative portfolio rather than an absolute portfolio.
Hedging the currency risk comes at a cost. Today, that cost would amount to around 1.8% per year, reducing the yield from around 2.4% to 0.6%. However, while hedging the currency reduces the yield on US Treasuries, it doesn’t remove the capital gains that investors would benefit from if Treasury yields fell during a recession, as the Fed cut rates. So even though the hedged yield on a US Treasury is low, the potential for capital appreciation during a downturn remains.
In the last few months, a seemingly more dovish Fed also appears to have reduced some of the upside risk to Treasury yields, and hence the downside risk to their price. While Treasury yields could still rise further from here if growth, interest rates or inflation expectations pick up, as a recession hedge, Treasuries hedged into sterling should be pretty reliable.
In addition to Treasuries, strategies such as global macro funds, which can bet that volatility will rise or that equities will fall, also have the potential to make money during a downturn, if the fund manager correctly anticipates the risk. These strategies* are one of the few types of fund that made gains during the last two recessions.
So while the timing of the next downturn remains uncertain, investors might want to consider adding in some portfolio hedges in the form of currency-hedged Treasuries and global macro funds to help balance the riskier assets in their portfolio, as we move later into the economic cycle.
*HFRI Macro index. See “How should we prepare portfolios for the next downturn” on our website.
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