‘Ottawa’ Preparing Your Portfolio for the Next Market Selloff
There’s often strength in diversity, but some investors who have diversified their portfolios have found themselves in a conundrum. Their assets have begun to move in unison. An unusual alignment between oil prices and certain assets is to blame, says Kurt Reiman, chief investment strategist for BlackRock Canada — and investors may have to work harder to diversify by looking to options such as government bonds, gold and minimum-volatility strategies.
“Since the 2008-09 global financial crisis, a broad array of risky assets, including commodities, have tended to move in lockstep during times of panic and heightened uncertainty,” says Reiman. “The fall in oil prices that culminated in big declines for stocks, emerging market assets and high-yield bonds at the beginning of this year is the most recent manifestation of this linkage. When so many assets move down together, like they did in January and early February, many investors were left wondering what happened to the diversification benefits they expected when they needed them most.”
Reiman notes that a collision of forces has forged an elevated relationship between commodities, emerging market debt, speculative grade bonds and stocks. Prior to 2014, expectations that emerging markets would continue to demand more oil boosted oil prices and saw a debt-financed buildout of additional energy resources to meet that perceived need.
“The dollar suddenly strengthened beginning in 2014 and emerging markets decelerated more quickly than expected,” says Reiman. “Assets tied to industrial commodities output or geared to the global economy then turned down together.”
More recently, some investors have benefited from the elevated link between crude and other high-risk assets, such as stocks, emerging market assets and high-yield bonds. That’s because stronger oil prices, flirting this year with US$50 per barrel, have floated these boats simultaneously, according to Bloomberg data.
“But what happens if another bout of risk aversion grips financial markets and crude prices drop back into the $30s?” asks Reiman. “Although recently rising prices for stocks, high-yield bonds, commodities and other riskier assets would suggest otherwise, investors remain skittish over unresolved risks facing financial markets.”
Issues on investors’ minds include a contentious U.S. presidential election, the possibility of extensive post-Brexit negotiations, Italian bank solvency and slow growth in China. “These uncertainties have likely prompted central banks to roll out even more monetary stimulus, which in turn has likely lifted asset prices and given the false impression of a backstop against further sharp declines,” says Reiman. “We expect more volatility ahead and wouldn’t rule out another risk-off event in the months to come.
Investors, therefore, may want to take a closer look at assets that can help offer more robust diversification benefits and downside protection if trouble hits the oil patch again, resulting in another synchronized decline across a spectrum of riskier assets.
Reiman notes that government bonds continue to exhibit a low correlation to oil prices and commodity cyclicality in general. Although sovereign bonds are expensive at the low yields offered, they can play a role in a diversified portfolio.
“Gold is another option to consider given its low correlation to other assets,” he says. “With rates low, some early signs of reflation and central banks in a stimulative mood, gold prices could be a good hedge against financial market stresses.”
Investors may also want to inoculate their portfolios against macro factors, such as changes in economic activity and oil prices, by pursuing minimum volatility and multi-factor strategies.
“Low and negative interest rates across the globe have inspired flows into stocks, emerging-market bonds and corporate credit in search of higher yields,” says Reiman. “But consider the high correlations of these assets to oil prices and the advantages of holding actual diversifiers in your portfolio to smooth the ride.”
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