Choose your defender
Steve Thaxter- Senior Partner and Principal Adviser
Sovereign Wealth Partners
When investment markets are unfriendly the defensive assets in your portfolio are supposed to step up and earn their keep. So far in 2022 investment markets have been pretty unfriendly, leading to negative short-term performance. This article looks at the common defensive assets – cash and term deposits, bonds and gold. How well are they suited for the current environment?
But firstly, what are we defending against? Let’s say it’s the risk of short-term losses in traditional growth assets like shares and property. The main risks worrying investors today are inflation, rising interest rates and geopolitical tensions. Specifically, Australian inflation is now running at 3.5% (the official reading at the end of 2021) and expected to peak at around 5-6% before drifting down again. Inflation is much higher in the US; 7.9% to the end of February 2022 and rising. Supply chain disruptions from the Ukraine war, Russian sanctions and Covid largesse are to blame for much of this, but Central Banks around the world are belatedly remembering they have a mandate to keep inflation in check.
If we accept that inflation is caused by an excess of demand over supply, then the traditional Central Bank response is to cool demand by raising interest rates. Anticipating this and responding to the sudden jump in inflation in 2022, interest rates across financial markets have jumped too. And as interest rates are the price of money, when money is more expensive investment prices fall. Things change quickly and today’s financial markets are priced for Australia’s official cash rate to be above 3% by the end of next year. This would translate to variable mortgage rates of around 6%. A scary prospect for borrowers and a very different story to what the Reserve Bank of Australia was telling us just a few months ago.
So having considered what markets are worrying about, let’s consider the traditional defensive assets in turn.
Cash and term deposits
The defensive part is easy to understand. A portfolio with, say, 50% shares and 50% cash will only fall half as far in a downturn compared to being 100% in shares. But it only has half the upside. Cash and term deposit income is, sadly, well under 1%. So the income is not much help at all. But cash has other redeeming features.
A healthy cash buffer allows spending without the forced sale of a growth asset that’s temporarily devalued. And it has optionality – with a big cash buffer you can wait and buy in to cheaper investment markets later. The trouble is, when cash earns close to nothing and inflation is rampant, your spending power is going backward at a rate of knots. So right now it’s expensive to hold cash other than as a short-term tactic or to finance future spending across a fairly short time horizon. And if interest rates are really going to rise to 3% over the next year, there will soon be a nice jump in term deposit rates. So think carefully about timing when considering the term deposit market today.
Bonds have two big advantages over cash. Firstly, they pay a yield that is normally better than cash and secondly, in most periods when share and property markets went down, they have appreciated in value. Doesn’t that sound perfect? If there is a negative correlation (one goes up when the other goes down) the diversification benefits of bonds are better than cash. This means that not as much portfolio capital needs to be diverted away from growth assets for the desired reduction in portfolio risk. We’ve been used to this for a very long time – bonds done very well for over 30 years as inflation and interest rates have been mostly on a downtrend. But sadly, it works both ways. When inflation expectations rise, interest rate expectations rise and bonds fall in value. This is exactly what we’ve seen this year. Its been pretty much the worst quarter for bonds in 30 years. A typical traditional bond fund has fallen over 5%. This is not what we want from a portfolio defender.
But from here we must look forward not backwards. If the bad news is now “priced in” and if cash rates don’t reach 3% in a year’s time, bond funds would likely do quite well for the next year because we’ll be back to falling interest rate expectations. This is the rationale for persisting with this asset class – it’s now better value and better equipped to fulfil its defender role.
As a commodity, the price of gold is set through demand and supply dynamics. Gold pays no yield and therefore the investor is totally reliant on price appreciation through future demand at least matching the supply of those looking to sell. In this sense it’s hard to justify gold as a defensive investment. However, in periods of uncertainty and share market weakness gold has generally performed well and, unlike bonds, it tends to do well during periods of rising inflation. And this year gold has stepped up nicely. Prices are up around 10%. In fact it’s done pretty well in most of the major downturns for the last 50 years. So far so good. But when the yield is zero it’s very hard to put a meaningful valuation on an investment asset. Could we be buying into a bubble? It’s hard to know at the time, but perhaps history can guide us. Gold has been traded for a very long time with some very large price cycles. After adjusting for inflation, the real price of gold is now close to historic highs. According to Farrellys, the inflation adjusted (real) price of gold has only been this high three times in the last 600 years. Each time it got there it’s fallen away fairly quickly. This raises the stakes when considering gold as a defender. It’s done well recently but could easily go against us and leave us with big losses. For example, over the twenty years to 2001, it actually lost 80% of its value in real terms. And that period had quite a lot of inflation in it.
The bottom line
The bottom line is that there is no perfect defensive investment in portfolios. In the world of investment, there are risks everywhere. So why not just hold growth investments? Without any defensive investments, the long-term portfolio return expectation will be higher. But the problem for most of us is that the short to medium term risk of a 100% growth asset strategy is just too high. Remember that share markets around the world halved during the global financial crisis of 2008/9. Private asset and housing markets were on their knees. This may well have been a once in a generation event but we just don’t know when the next big crash will be.
So like it or not, we all need to carefully choose our defences. There are various options beyond the traditional defenders discussed above. These include private debt, corporate credit, hybrids (income securities), infrastructure, hedging and structured products. Each has some defensive traits and a different set of risks. As is so often the case, diversification is our friend and a carefully considered blend of defenders may be the best recipe for you.
 Assuming we are talking about real cash, backed by a real bank or authorised deposit taking institution.
 Assuming we are talking about high grade government and corporate bonds with minimal credit risk.
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