Name any financial crisis that happened in the last 15 or so years, and I will be able to tell you (while closing my eyes) what firm I worked for, what market forces our portfolios were roughly exposed to, and how they fared in the end. The global financial crisis in 2008/2009, the eurozone sovereign debt crisis in 2011/2012, the taper tantrum in 2013, the volatility emanating from China in late 2015, and so on.
Yes, everyone remembers the big one of of the late noughties, but we’ve had some volatility along the way as well. Question is, when is the next big shock happening, and how does one even begin to position a portfolio for that? The truth is that foreseeing the next reason for markets to turn volatile is extremely difficult (at the moment geopolitics and central bank policies come to mind as most likely sources – but who really knows?)
Yet at the same time we know that nowadays assets are classified as either “risk on” or “risk off” assets and will respond accordingly during any crash scenario. Markets have become very black and white in that sense.
The portfolio I propose here can be a smaller allocation of your portfolio as a whole, and will offer resilience in times of market stress.
Assets to avoid during the next market crash
The funny thing is, everyone was talking about diversification until the global financial crisis hit. As we now understand better, correlations between non-normally distributed returns can behave quite differently during periods of market stress than they might otherwise, and fat tails in individual asset returns can be exacerbated by their comovement together (or in simpler terms: correlation and risk management based on correlation is like a safety belt that always works, except when you have an accident!)
Many people have written about the “everything bubble” and predict that the future market crash will be as severe if not worse than the global financial crisis of 2008. We would be talking about a crash of at least -40% in equity prices, with commodities, property and fixed income credits moving right along in the same direction. While it is impossible to say what will really cause the next bout of prolonged equity sell-offs, at the moment it seems most likely to get started due to either a geopolitical event, US monetary policy, or simply the next recession.
Assets to invest in during the next financial crisis
Just like we can be fairly sure that equities are going to sell-off, there are also some near absolute certainties around assets that will do well during the next crash:
- Gold. the ultimate safe haven asset, a store of value that cannot be manipulated by any government and is expected to hold its own in times of uncertainty. Between January 2007 and December 2008 gold rose by +35% in value
- US Treasuries. the only “risk-free” assets in the world, right? In times of volatility these instruments tend to perform well as investors seek a refuge from sell-offs in other markets. In 2008 the 10 year yield declined from 3.6% to 2.2%, while in 2002 it declined from 5.0% to 3.8% (declines imply a positive return on the bonds).
- Safe haven currencies. JPY and CHF are classic examples of currencies that tend to strengthen in times of market stress. See any bad headline and you can expect these to respond near instantly. Between June 2007 and Dec 2008 Japanese yen strengthened from 123 to 91 (+35%). A lot of this is self-filling prophecy, but obviously investors do put a lot of faith in these countries’ governments and central banks.
3. How likely is this theme to play out?
Equity markets have seemingly been going up since forever. Early 2018 saw a bit of volatility, but ultimately we are due for a bigger correction somewhere down the line. Currently we’re in what everyone seems to call a “goldilocks” environment, but I’d say there’s a 50% chance of a huge sell-off somewhere between now and 2020. However, given that losing out on the ongoing equity rally may in the end hurt your returns more if the crash doesn’t arrive for several years, I’d suggest to right now only stick 5%-10% in this sub-portfolio and regularly revisit as markets change.
Portfolio construction: gold, US treasury, JPY and defensive equity/HY
- The below portfolio consists for 75% of classic safe haven assets that will almost be guaranteed to deliver positive returns in all reasonable scenarios for the next market crash. Gold, US Treasuries and long JPY.
- Since you do want to keep some upside and yield, I’ve added exposure to defensive equities and defensive high yield credit bonds. These will generate returns and good yield during normal markets, but will absolutely sell off during the next crash. The caveat is that they won’t sell off quite as fast as some of their non-defensive peers
- This portfolio has therefore been constructed to offer upside during normal markets, but give close to 0 returns during extreme bouts of volatility
- Portfolio characteristics are shown below: a volatility of 7.5%, benefiting from equity upside by +7.2% (a replay of the rally of 2009) and losing only -1.2% during the 2008 Lehman Brothers default period
|Gold||SPDR Gold Shares||GLD||03/2018||-||0.40%||50.0%|
|Defensive equity||Guggenheim Defensive Equity||DEF||03/2018||04/2018||0.60%||0.0%|
|Defensive HY credit||iShares Edge HY Defensive Bond||HYDB||03/2018||-||0.35%||12.5%|
|US Treasury||iShares 7-10 Year Treasury Bond ETF||IEF||03/2018||-||0.15%||12.5%|
|Long JPY||ETFS Long JPY Short USD ETF||LJPY||03/2018||-||0.39%||12.5%|
|Defensive equity||iShares Edge MSCI Min Vol Global ETF||ACWV||04/2018||-||0.20%||12.5%|
Risk, diversification and allocation
- Risk level: low to medium
- Diversification: high
- For risk and total return since initiation see Portfolios
- Probability of this theme playing out in the next 3-10 years: 50%-100%
Portfolio characteristics (full look-through, from USD perspective)
- Dividend yield: 1.0%
- Ex-ante predicted volatility: 7.3%
- 1 year 95% Value-at-Risk: -11.2%
- Scenario 2008 Lehman Brothers default period: -0.6%
- Scenario Interest rates +100bps: -5.5%
- Scenario 2008-2009: +10.2%
- Scenario 2010 onwards: +32.6%