As investors seek out safe haven assets, Standard Life Investments global thematic strategist Frances Hudson analyses just how well these may cope with various threats.
Firstly, while there are obvious areas of concern and even specific risks, there is no agreement on what the main dangers actually are. Even in the relatively straightforward arena of economics, there are deep divisions. With policy rates held at low levels for prolonged periods, excess liquidity is a feature. Savers are concerned about inflation detracting from potential income and eroding wealth. For others, deflation is a more serious long-term threat, linked to demographic developments and the ensuing low growth environment, making tackling indebtedness the priority. The distinction is important because it determines policy responses. In Europe, tackling the threat of inflation is paramount, whereas for US and UK policymakers current inflation has been seen more as a temporary phenomenon, with debt and deflation the lurking
danger. Of course, some of the differences come down to priorities and timeframes, with some measures to counter immediate and cyclical problems appearing perverse in the context of longer-term structural issues.
The second issue is connected with lessons from recent experience. Liquidity attracted a premium during the early part of the Global Financial Crisis (GFC), but, as the problem moves from liquidity to solvency, a better strategy may be to seek assets which are better stores of value and wait out the crisis. This involves extending duration rather than bringing forward cashflows.
The third factor concerns the effectiveness of diversification. Here, awareness of connections within and between asset classes can help. Correlations rise at times of crisis and have risen to elevated levels in recent years as investors have followed similar paths in trying to diversify their portfolios and reduce risk. Crowded trades serve to boost correlations. Within equity indices, the gap between the best and worst performing stocks, i.e. the dispersion of returns, narrowed considerably in the run-up to and aftermath of the GFC. Our research shows the diversification potential of a large-cap equity index more than halved in the three years to 2008 and has remained low.
Investors behaviour has also affected the relationships between commodities. Because investors often choose Exchange-Traded Funds (ETFs) that track a broad commodity index rather than invest in a single commodity, correlations between commodities have risen. In the case of gold, which shares few drivers with the more cyclical industrial metals, the move has been less
dramatic but is still significant. Average correlations across key commodities have increased.
Traditional relationships between asset classes have also changed, with less diversification potential. Commodities and equities became positively correlated in the aftermath of the GFC whereas they had previously moved in opposite directions, making commodities less useful as a way to diversify portfolio risk. Similarly, the relationship between government bonds and equities varies over time and depends on the level of bond yields. During periods of ultra-low yields, which coincide with a poor economic outlook and companies struggling to generate growth, bond prices are more likely to move in the same direction as equities.
Bills, bonds and currencies
High-quality government bonds have historically performed well as a hedge during economic downturns and market crashes. They did better than either gold or the Swiss franc in the immediate aftermath of the collapse of Lehman Brothers.
The market, particularly for US Treasuries, is large and liquid, a desirable characteristic for a safe haven. There is an argument though that the limited potential for further moves down in yields will render bonds less effective in shielding portfolios in future.
The US dollar, the Swiss franc and the Japanese yen have been the currencies to which investors retreat in times of peril. However, the willingness of the Swiss National Bank to intervene and stem the appreciation of the franc effectively removed it from the game. While there is a desire to move away from the dollar, both in recognition of structural problems in the US and generally to diversify holdings, there is a shortage of alternatives that are large and liquid enough to cope with the sizeable flows involved. Free-floating currencies representing countries with stronger economic fundamentals and less sovereign risk, such as Norway, Sweden, Australia or Canada, simply do not have the capacity, while excessive appreciation could prompt intervention. That is even more the case for emerging market currencies. Commodity currencies are also more exposed to cyclical influences.