(Bloomberg) -- Flying into a spot of turbulence isn’t the perfect time to be told your seat belt might be faulty.
Yet that’s the situation facing investors today, as analysts warn that standard hedging strategies that have been built into portfolios for decades may no longer be effective. With correlations between asset classes swinging from positive to negative and back week by week, the traditional approach of buying bonds to balance equity risk isn’t much use, according to Olivier d’Assier, Axioma’s head of applied research for the Asia-Pacific region.
“They may lose the diversification they’ve built into their portfolios,” d’Assier said of fund managers, speaking in a telephone interview. “They’re looking for ways to hedge,” and in some quarters are turning to inflation-linked Treasuries and credit default swaps, he said.
The volume of emerging-market CDS trading hit a record in the first quarter of 2018, even before last month’s sell-off engulfed assets from Argentina to Turkey, according to EMTA data. In April, 60-day volatility in Markit’s CDX North America Investment Grade Index rose to its highest in at least six years. Last week, the same measure of volatility in the iShares’ TIPS ETF, which tracks inflation-linked U.S. government bonds, rose to a seven-month high.
One of the key obstacles for traditional hedging strategies is the impact of the wind-down of global central banks’ quantitative easing programs. With the specter of inflation rising just as key central bank balance sheets start to shrink, that’s undermining bonds and their utility as a hedge to stocks.
“The concern is that in the next downturn, do fixed-income securities have the same buffer as in a traditional cycle? Maybe not, because interest rates are so low,” said Christian Nolting, global chief investment officer at Deutsche Bank Wealth Management. “So you lose on both sides of the major asset classes.”
The return of volatility in a number of asset classes this year after a preternaturally calm 2017 has given urgency to the hunt for hedges. “Pop-up thunderstorms” are a consequence of the Federal Reserve’s balance-sheet contraction since late 2017, which has tested some of the weakest links in capital markets, according to Michael Wilson, chief U.S. equity strategist at Morgan Stanley.
Among the blow-ups have been cryptocurrencies, benchmark interbank dollar rates known as Libor, short bets on volatility products, European bank stocks, emerging market securities and Italian bonds.
Next in line could be growth stocks, which have been used by some investors as hedge against inflation and have seemed a good bet in an environment of a synchronous global expansion.
“These dislocations have also led to even more crowded positioning in what investors deem to be defensive assets,” such as the shares of growth-oriented companies, Wilson said. Some of them “may not prove to be as defensive as expected,” he said.
Deutsche Bank is recommending floating-rate notes for those who want to reduce portfolio risk. Also on the list: structured products that provide some capital protection, and the use of swaptions, which provide a hedge on interest rate risk by granting the right to pay a fixed-rate on a swap contract.
“What you need is something that’s uncorrelated to both fixed income and equities,” Nolting said. “It’ll be a massive theme over the next few years.”
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