10 January 2019
What Can a Bear Buy?
A lack of investment safe havens.
By Frank O’Nomics
Regardless of whether you think there is value in markets, the huge level of geopolitical uncertainty and wild volatility of most asset classes encourages taking a step back and adopting a defensive investment stance. After a December where the hoped for ‘Santa Rally’ failed to materialise, the New Year has already seen markets experience a fresh dose of whiplash, with daily swings of greater than 4% in some equity indices. The combination of a global slowdown (led by China), ongoing trade wars and the ever-present Brexit conundrum are conspiring to make the market for most asset classes both sensitive and very vulnerable. At times like these, many would be content to moderate their return targets and sacrifice the opportunity cost of being out of markets for some general peace of mind. The problem is that what we would normally regard as defensive investments are potentially anything but, leaving the dilemma as to where to put our money. So just what can the faint-hearted or outright bear buy?
It you think that there is significant risk of equity markets suffering an appreciable setback, the obvious answer is to sell. Holding cash deposits or supposedly ‘risk free’ assets, such as high rated government bonds, would normally protect the value of portfolio during a period of extreme uncertainty and volatility. However, in the current environment such choices may actually guarantee an erosion of value. A significant proportion of short-dated government bonds, particularly those of Germany and Japan, offer negative yields, meaning that you effectively pay for the guarantee that your money will be repaid to you on the bond’s maturity. In those markets where bonds offer positive yields, such as the UK and the US, those returns are still generally insufficient to offset current inflation. Hence, in terms of real return you are still getting less back than you invested. Cash, as an alternative to bonds, is arguably a worse option – the interest rates offered on even longer-term deposits are also well below the level of inflation and, beyond the £85,000 that is protected under the FSCS, your money is still at risk.
If lending to governments is too expensive, what about lending to better quality corporate entities (many of whom are more highly rated than some governments) by buying their bonds? Buying shares may be risky, but surely lending to companies is safer. That may be, but the effects of quantitative easing, which saw huge buying of such bonds by both governments and savings institutions, left them as expensive and vulnerable as the equities of the same companies. 2018 saw corporate bonds deliver their worst return since 2008, with the yield margin of investment grade bonds over governments widening by 0.75% – and for those brave enough to buy lower rated high yield bonds the deterioration was close to 2.5%. Yet this under-performance only follows many years of out-performance, which still leaves considerable scope for this asset class to cheapen further.
Ok, so what about just becoming more defensive within our equity portfolios? The choice of lower volatility stocks, which still generate inflation-beating dividend yields, may sound like a happy medium – we can never perfectly time buying and selling equity markets, so keeping a lower risk exposure, by selling cyclical stocks and buying defensive stocks, may be a better alternative. The stocks to avoid if the economic cycle has turned are easy to identify – people will not be buying discretionary consumer goods, and companies will not be borrowing from banks or increasing their demand for raw materials. Similarly, the demand for real estate will be significantly reduced, and all of these sectors are strongly correlated with equity markets overall. The more attractive areas then should be those with a much lower correlation to world equity indices, typically sectors where demand is constant regardless of the economic cycle. People have to buy food and energy, will continue to require key utilities and may in fact have a greater demand for healthcare. The problem here is that standard defensive stocks have become more vulnerable due to the particular circumstances that we face – especially in the UK. On the face of it, utility stocks look very attractive. SSE plc, for example, has a dividend yield of 9% and a price-earnings ratio below 9. However, part of the reason for this cheap valuation is the fear of a Labour government and the potential nationalisation of such companies. Demand for electricity may be undimmed, but the nature of the supplier could change. Consumer staples could be a safer defensive play, but this area has been the subject of intense competition for a number of years, with the likes of Tesco, Sainsbury’s and Morrison’s having to cut margins to compete with Aldi and Lidl. Nevertheless, the market does point to some steadier ships, and Unilever, Glaxo and Diageo have all been cited as closer to recession proof.
So is that the answer? Focus on ice cream, marmite, amoxicillin and stout? Well, there may be another way of protecting your money through a potentially difficult year and that is by buying government bonds that protect you from rising inflation. The UK, US, many European governments, Australia and Japan all issue bonds that pay interest linked to the national rate of inflation. In the UK these bonds are very expensive due to excessive demand from pension funds, but in the US a 20-year inflation linked government bond pays almost 1% over inflation. For a UK investor you do take the risk that the $ under-performs the £ and clearly you will care more about UK inflation rather than that in the US, but the how big is this risk and uncertainty compared to all the others?
As for other alternatives, the most negatively correlated asset with world equities historically is gold (-10% over a 17-year period) and recent price moves in bullion point to a degree of support. However, the point in holding an asset that produces no yield when we can have the protection of inflation-linked bonds is hard to justify. You could of course put your money into Bitcoin (what a good call that was last year!). Alternatively you can stick your head in the sand and wait for markets to turn back up. That is exactly what most investment advisers seem to be doing, with one recently suggesting, “There are plenty of smart investors betting risk appetite will normalize soon enough”. Just how ‘smart’ they are remains to be seen.
