Category: Financial and economic

Late cycle investing: where to put your money at the tail end of the expansion

We are still in the expansionary phase of the business cycle, a place we have basically been in since June 2009. And although the old adage goes that “bull markets don’t die of old age”, most would agree that we are now in or at least nearing the tail-end of the cycle. That is typically associated with an overheating economy that faces tightening monetary conditions and credit availability, slowing productivity and GDP growth that begins to stall. Not great news, all in all.

With interest rates going up and economists anxiously looking at economic data to spot either a pick-up in inflation or slowdown in the economy, stocks have been showing the first real signs of bull market fatigue in early 2018. They recently broke through their 200 days moving average for the first time in 2 years.

Once the bull market ends and things turn down, there won’t be many places to hide except for cash, gold and treasuries (and maybe, just maybe a select few consumer staples stocks). But calling the end of the rally has been unsuccessful for many, and DT’s fiscal stimulus plans may yet extend things for quite some time to come. Until it all comes crashing own there may still be decent returns to be found in certain places of the market. Here are three investments you could consider.

#1 Non-US equities

While the US may be nearing the end of the good times, in Europe and many emerging markets, the expansion is still very much going on. Europe in particular seems a step behind the US in terms of the business cycle, having been slower to recover from the previous bear market. With still low inflation and interest rates, and growth having missed out on the strength of the recovery that the US saw post crisis, European equities should have some room to run still. Emerging markets have also been showing notable resilience to recent US-led market volatility. Investing in these two markets may yet yield good results, bar a total systemic crash like we saw in 2008.

#2 High quality stocks and specific sectors

Defensive sectors like utilities, healthcare, energy, and consumer staples would generally be expected to perform better than their cyclical peers in this period. Also more generally, companies with stronger balance sheets (which tend to pay higher dividends) will be expected to stand firm while their more speculative peers take the brunt of the initial hits.

#3 Commodities

A key aspect of the late business cycle is that inflation should start picking up. Inflation-sensitive sectors like energy and commodities are expected to outperform off the back of this.

Portfolio construction: cash, commodities, non-US and high quality stocks

  • The suggested portfolio contains a lot of cash to cushion the blow that a recession will undoubtedly deal the markets at the end of it
  • Until then, commodities, European and Asian equities as well as high quality US stocks should be expected to perform better than the market as a whole
CategoryNameIDTERAlloc %
Asia equityiShares MSCI All Country Asia ex Japan ETFAAXJ0.69%10.0%
Europe equityiShares MSCI Eurozone ETFEZU0.48%10.0%
High dividend low volLegg Mason Low Volatility High Dividend ETFLVHD0.27%20.0%
CommodityiShares Commodities Select Strategy ETFCOMT0.48%30.0%

Risk level: low / diversification: high

  • Dividend yield: 2.6%
  • Ex-ante predicted volatility: 5.7%
  • 1 year 95% Value-at-Risk: –8.8%
  • Scenario 2008 Lehman Brothers default period: -11.6%
  • Scenario Interest rates +100bps: +1.7%
  • Scenario 2008-2009: -5.8%
  • Scenario 2010 onwards: +55%

Constructing a Portfolio with Low Risk and High Yield

If there is such a thing as the holy grail of investing, it is probably to construct a portfolio that exhibits low volatility in combination with a high level of yield. While that apparently goes against the ground rules of investing which say that risk must be commensurate with returns, research in recent decades has shown that over the longer run, stocks with lower volatility have actually outperformed their higher risk peers. That opens up a world of possibilities.

But simply picking high yielding low volatility stocks is not going to do the trick, as I will outline below. While such a portfolio may beat other equities, it will still leave you with significant levels of risk and exposed to large losses in case of a 2008-style stress event.

Instead, in this article I will tell you how you can construct a better diversified portfolio that achieves high levels of yield using not only low volatility equities, but also other asset types.

The portfolio below achieves our aim of a high yield at an even lower level of risk, while also faring far better than the broader market in even the worst of the market downturns that we have seen. Naturally, there are some risks and caveats to this “having your cake and eating it” strategy and I will highlight those as well.

More than 5% yield at less than 5% volatility?

When talking about low volatility and high yield we should be aware that they are both very subjective terms, take the S&P500 today for instance:

  • In its regular form its volatility is 15% at a dividend yield of 1.9%. In 2008 it returned -38%
  • Its low volatility high dividend variant (S&P Low Volatility High Dividend Index) has a volatility of 13% at a dividend yield of 4.4%. In 2008 it returned -24%

The second index clearly improves on the former, but in case of a 2008 style crash it would still take you more than 5 years to recoup your losses on dividend yield alone, that is on the assumption that companies would even keep paying.

Most of the minimum volatility ETFs that are currently out there don’t have sufficient history to tell us how they would have fared in 2008, but if we look at the recent bout of market volatility (Feb 2018), we see that the iShares Edge MSCI Minimum Volatility USA ETF returned about -9.2% in a two week period. That raises my eyebrows a little.

Making things worse, I am hard pressed to call 13% a low level of volatility even in normal markets. If you invest $100,000 and I tell you that in a normal scenario by year end you’d have a portfolio between $87,000 and $113,000, would a low-risk investor be happy with that? Probably not.

So how can we further improve on this? The key is to search for other asset classes (or high yielding subsets thereof) that complement low risk high dividend equities and offer similarly high yield, but diversify some of the volatility away.

I will outline such an ETF portfolio below that delivers more than 5% annual yield (income) at less than 5% volatility by combining low volatility high yielding stocks from different markets, with bonds, preferred REITs and senior loans.

Per estimations from the risk model (Bloomberg PORT), in a 2008 like stress event it would take this portfolio less than 3 years to recover on yield alone, compared to 5 years or more for most low-vol high-yield equity portfolios, or well over a decade for a regular equity portfolio.

Why do investors like yield?

Total return = yield + capital growth

Total return consists of both capital growth and income or yield. Yield can be gotten from sources like bond coupons, stock dividends, rental income or indirectly through ETFs that distribute the yield they reap, and many investors view it as a current income stream.

They are not too concerned with markets moving up or down somewhat, as long as the longer term trend is up and yields keep being paid. After all, cash in hand is better than a position in a security that may drop in value any second.

With bank deposit rates in developed markets are still very low, bond yields having become compressed yet at the same time equity markets looking scary being at all-time highs, investors are increasingly looking to risky assets to provide the income that they are not able to find it in traditional low-risk places anymore. That’s the purpose of yield.

If I had invested in the S&P500 since 2000, my total capital growth would have been +81%, while my total return would be +156%. Roughly half of that can therefore be attributed to yield, and that is what we are searching for here

Stock dividends and bond yields are relatively stable, providing a cushion for volatility. If you hold a 5% dividend paying equity, then 5 years down the line you would have earned sufficiently to break-even with the occasional -25% stock decline.

While when it comes to equities, dividend paying stocks may actually be less risky than their peers as they tend to be more established companies, with bonds it is the other way around. Income from bonds is inherently related to risk (a lower credit quality means higher borrowing costs for firms, which investors can benefit from if the firms manage to stay afloat until their debt matures). Sound risk management therefore needs to be applied.

But low volatility does not necessarily mean low risk

Volatility, which is typically used as a proxy for risk, tells you something about the most recent risk level of an asset. It tells you how wildly an investment can swing up or down in normal market conditions, with 84% certainty.

Pre 2008 there were equities that exhibited lower volatility than their peers, yet when the market crash came they still sold off by 25% or more. That is not exactly low risk, but still not bad if you realise that the whole market lost nearly 40% in value around that time.

This is why I personally like to view the risk level of an asset in two ways: their current volatility, and the amount you could stand to lose in a true stress event. Markets are currently in a low volatility environment. This can lull us into thinking that some equities are “defensive”, “low volatility” and therefore offer equity-like upside without the downside.

Indeed, compared to their peers their risk-return trade-off is superior (which may be driven by anything from human behavior and preferences to sector-specific dynamics), but when a systematic crash hits markets you can still expect everything to go down the drain at the same time.

So simply picking a low volatility equity ETF is not going to cut it. The portfolio I am constructing here should have overall low volatility, but it should also not suffer too much during a stress event.

Therefore diversification is still key

Low volatility investing has generated superior risk adjusted returns over the long term. It goes against standard market theory that more risk is rewarded with more return. Behavioural biases, rebalancing effects and investor constraints are common explanations for the low volatility premium. (AON, “Factor Investing: What’s the big deal with low volatility equities?”)

Only high yield and superior risk-return characteristics within each asset class is not going to be sufficient. We want to increase the risk-efficiency of the portfolio and obtain high expected annual yields yet at the same time achieve lower overall volatility than simply the weighted average of the components. In addition, we want to minimise the damage the next market crash can do.

The chart above shows (March 2018) risk levels vs current rolling annualised 3 year returns for various asset classes. Note that this shows total return rather than yield, so it does not necessarily paint a perfect picture of which assets are high yielding (the yield on gold is precisely 0.0%), but it goes a long way.

What we are essentially looking for here are asset classes where volatility and returns are at least close to each other if not better, preferring lower volatility. Based on the past 3 years, S&P500 Low Vol High Dividend, EM Bonds, Preferred REIT and Global High Yield look particularly appealing.

So low vol high dividend equities are a given and going to be a part of our portfolio. What asset types exhibit low correlation with these investments? Again Preferred REITs and EM Bonds stand out.

So what assets should we invest into?

We therefore need to think about adding some other assets into the mix, preferably those that can offset some of the shock in stress scenarios, while still delivering a decent and sustainable yield. I scanned the ETF universe for funds across the asset classes that had the lowest 90 day volatility and the highest yield levels, and found good ETF candidates in all of the below asset types.

This incorporates the EM bonds, high yield bonds, low vol high dividend equity and preferred REITs that we had already picked up above. In addition, senior bank loans stand out as an asset class that adds both diversification and yield.

  • Minimum volatility equity. Scientific papers have actually proven that minimum volatility equity works to improve risk-return characteristics, which is also obvious from the popularity of such products. During 2008 the 100 lowest volatility stocks of the S&P500 returned -24% while the index as a whole lost -37%
  • High dividend stocks. High dividend stocks tend to have lower volatility (and there thus appears to be quite a bit of overlap with minimum vol equities), be more established business and help build up a cushion to cope with the next stress event
  • Preferred stocks of REITs. Preferred securities issued by Real Estate Investment Trusts offer high quarterly dividends and low beta equity exposure. A risk is that these securities tend to be callable (which may lose you money if you buy at a premium to par) and increased interest rate risk. However correlations with other asset classes are lower, volatility is in between bonds and stocks and yield is high
  • Senior loans. floating rate securities are notes issued by banks or other financial firms that typically have volatility higher than investment grade bonds
  • Unconstrained bonds. Typical global fixed income funds have high duration and low yield, and practically only exposure to developed markets. Unconstrained bond funds are able to reduce much of the interest rate risk and add on a healthy dose of yield by investing in emerging markets or high yield corporates. Should in theory be able to weather any market conditions and have lower correlation with other asset types

Portfolio construction: 5 high yielding ETFs

  • The suggested portfolio consists of 5 high yielding ETFs within low volatility equity, senior loans, high dividend equity, preferred stock of REITs and unconstrained bonds. Or at a higher level about 40% equity, 20% preferred equity and 40% fixed income like instruments. The correlation between all constituents ranges from -0.7 to +0.4, the entire portfolio is therefore highly diversified
  • This achieves a volatility of 4.8% versus a yield of 5.2%, which is seriously impressive. However during a 2008 style crash, the portfolio could still lose some 16%. But then at its yield, it wouldn’t take you more than 3 years to recover (or to start building up the cushion today)
  • I like this portfolio and reckon its a good addition to almost any other broader allocation, therefore I’d recommend an allocation of 10%-20%
CategoryNameIDTERAlloc %
Min vol equityiShares Edge Min Vol Europe Currency Hedged ETFHEUV0.28%20.0%
Preferred REITInfracap REIT preferred ETFPFFR0.49%20.0%
High DividendGlobal X SuperdividendDIV0.45%20.0%
Senior loansHighland iBoxx Senior Loan ETFSNLN0.55%20.0%
Unconstrained bondJPMorgan Global Bond Opportunities ETFJPGB0.55%20.0%

Risk, diversification and allocation

  • Risk level: low 
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 50%-100%

8. Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 5.2%
  • Ex-ante predicted volatility: 4.8%
  • 1 year 95% Value-at-Risk: -7.0%
  • Scenario 2008 Lehman Brothers default period: -15.4%
  • Scenario Interest rates +100bps: +0.4%
  • Scenario 2008-2009: -16.1%
  • Scenario 2010 onwards: +158%


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Making your Portfolio Stagflation Proof (when a Recession and Inflation Coincide)

For the last decade the biggest worry on economists’ minds has been deflation. Persistent low growth coupled with low interest rates have puzzled even the brightest minds in the field. We are not quite out of that supposed trap yet, though undeniably inflation has been moving upwards a bit over the last quarters.

As the labor market moves to and beyond full employment, according to economic orthodoxy we should now expect inflation to start rising. Combine that with tariffs which could raise the cost of imports and fiscal stimulus which likely comes at exactly the wrong point in the cycle, and you may see why some are worried.

What is stagflation?

In monetary policy, interest rates are lowered to stimulate economic growth. They are raised to battle inflation. That’s straightforward enough. Now let’s picture a situation of low economic growth and rising inflation. In a nutshell, that is stagflation.

The 1970s saw a famous period of rising oil prices combined with a recession, when interest rates went as high as 20%, the stock market lost as much as 40% and unemployment was raging. That followed a period of loose monetary policy aiming to generate economic growth and full employment. Sounds familiar? 2008 had a period where this happened that came dangerously close to it.

What assets to avoid during stagflation

During stagflation, interest rate sensitive assets and low yielding assets are best avoided. Interest rates are going up, and if you hold a 10 year US treasury bond with an assumed 8 year duration, you will lose roughly 8% for every 1% rise in rates (ignoring convexity).

You will also want to avoid REITs, while the return-above-inflation effect of stocks may only become apparent in the long run as companies may fare well with lower levels of inflation but may not be able to pass on higher levels of inflation to consumers that quickly.

What assets to invest in to protect against stagflation

Commodities are the classic inflation hedge, and prices of for instance oil and gold are expected to increase strongly during a stagflationary period. Inflation linked bonds will also hold their own, especially if inflation moves ahead of any changes to the central banks interest rates. Lastly, stocks of healthcare and consumer staples would be expected to fare better than the overall index as consumers can’t exactly choose not to eat or to pay for their medicines.

Portfolio construction: healthcare/staples, gold/oil and TIPS

  • This portfolio consists of 5 parts of 20% each in healthcare, consumer staples, gold, oil and TIPS. Healthcare and consumer staples should provide stock market beta and yield in case the scenario does not play out, while each of the other three components have diversification benefits
  • The 95% 1 year Value at Risk (expected max loss over 1 year with 95% confidence) is high at -19.2%.
CategoryNameIDTERAlloc %
EnergyVanguard Energy ETFVDE0.10%20.0%
GoldSPDR Gold SharesGLD0.40%20.0%
Inflation linkersiShares TIPS Bond ETFTIP0.20%20.0%
HealthcareiShares Global Healthcare ETFIXJ0.47%20.0%
Consumer staplesVanguard Consumer Staples ETFVDC0.10%20.0%

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: 10%-20%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 1.9%
  • Volatility: 7.6%
  • 95% 1 year VaR: -19.2%
  • Scenario 2008-2009: +2.1%
  • Scenario 2010 onwards: +109%
  • Scenario Interest rates +100bps: +0.1%
  • Scenario 2008 Lehman crash: -13.1%


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Positioning your Portfolio to Cope with a Trade War

Trade wars and threatening to start them are all the hype at the moment, it seems. Stock markets had a rough patch in late February to early March 2018 when the US President proclaimed on Twitter that trade wars are “good, and easy to win” and proposed 25% tariffs on steel and 10% tariffs on aluminum imports.

In the next days the headlines on imposing tariffs on Chinese technology became increasingly frequent. In both cases bureaucrats in China and the European Union took note and predictably went into battle mode rather quickly. When tariffs were finally announced, markets swooned again.

trade war refers to two or more states raising or creating tariffs or other trade barriers on each other in retaliation for other trade barriers. Increased protection causes both nations’ output compositions to move towards their autarky position. (Source: Wikipedia)

Coping with the onset of a trade war requires some ingenuity by investors. It requires answering questions such as which sectors are likely to benefit from protectionism and which sectors are likely to get hurt. Or whether the negative impact on the economy as a whole is bad enough to offset or exacerbate the impact on individual sectors. And whether short-term protectionism of a dying industry will really help that over the long run (after all, I am not a day trader).

Every case is going to be different, but here I will focus on the increasing trade issues between China and the US.

China vs. America: who exports what?

As of writing, the looming threat is that of a full-blown trade war between China and the US, with much of the rest of the world spared of Trump’s wrath. Ignoring the day to day headlines of what sectors may be targeted directly, let’s look at what products US-China trade is composed of:

  • The US exported $169.8 billion worth of goods and services to China in 2016, while China exported $478.8 back to the US, making it America’s largest trading partner
  • The main export categories from the US to China were misc. grains, seeds and fruits ($15 billion), aircraft ($15 billion), electrical machinery ($12 billion), machinery ($11 billion) and vehicles ($11 billion). Within agricultural products, soybeans and pork related products stand out.
  • On the other hand, the US mainly imported electrical machinery ($129 billion), machinery ($97 billion), furniture and bedding ($29 billion), toys and shoes. Within agriculture, fruits and juices stand out

So in all one would expect Chinese technology and machinery to suffer, while soybean, pork and aircraft producers could do well and their American counterparts would suffer. Foreign technology producers that export to the US but are based outside of China may benefit while similarly US manufacturing in slowly dying industries may see a temporary boost.

How would financial markets respond to a trade war?

Leaving the economics and politics of it all aside for a second, one thing is fairly clear: financial markets do not like anything that can have a negative impact on trade and global economic growth. When two heavyweights like China and America face off, consequences are likely to be felt in almost every part of the world.

In the period of 26 February to 1 March 2018 the S&P lost -3.7%, though it quickly gained most of that back in the days immediately after as markets processed Donald Trump’s bluster (and it turned out that every country and their grandmother could potentially get an exemption). At the end of March, indices again went down nearly -3% on announcement of tariffs on Chinese technology.

A brief trade war – one move and one counter move – that hits a few specific sectors will annoy markets and hurt for a few days (export-dependent companies in those sectors especially so), and blow over. Risk-off assets like gold and Japanese yen will perform well for a bit before returning to their means, while specific sectors may either be hit or benefit from all the turmoil. A prolonged trade war with tit-for-tat retaliation in a downwards spiral could be a whole different story and could be the cause for the next long term equity bear market.

So how will it all play out if it does happen?

Essentially I’d expect three things to play out during any trade war and all the negative news headlines that trade wars will bring along with it.

  1. Flight to safety: There will be a flight to quality in financial markets, likely short-lived but possibly pushing up or down the equilibrium levels of some safe-haven assets in the medium term. That means that as always, you will see a stronger Japanese yen and Swiss franc, gains in gold and positive returns on US Treasuries. At the same time, the US dollar may strengthen and equities and emerging market currencies will sell off hard. Typically this doesn’t persist for much longer than a few days, unless lasting economic damage and negative spillover to other sectors is expected.
  2. Direct hits: The sectors that are positively or negatively affected will show outsized returns. In this case it appears that US steel and aluminum producers may benefit, as will Chinese soybean and pork producers. In the case of tariffs on Chinese technology, those companies will be directly hit while the tech sectors of countries like Japan and South Korea may actually benefit.
  3. Indirect misses: Companies that are largely dependent on foreign markets, whether these are US, European or Asian companies, will sell off indiscriminately. Companies whose profits are mostly derived from their home markets will go down with the market, but will look relatively better than their peers. It should be noted that many of those companies will be small caps

The difficulty is that it is quite likely that the drag on the economy from tariffs is seen as so significant that the market beta is going to have the overwhelming effect on stocks. You may be able to find stocks that do better than their peers based on the above, but they might still sell off if only to a smaller extent. Even in the case of risk-off assets like US Treasuries there are caveats. China is the biggest holder of these bonds and in case of tit-for-tat retaliations could decide to dump them sparking large losses.

Finally, inflation linked assets like TIPS and commodities may do well as trade wars tend to increase prices.

How likely is this theme to actually play out?

It is very hard to say how trigger happy the American government is really going to be when it comes to this matter. Perhaps it is all a negotiating tactic, or perhaps not. It is equally unsure how other countries will respond. They want to be tough, but that toughness may come at the expense of their own economies.

While Trump is increasingly surrounded by hardliners which may push him to take action, we also know that Trump cares deeply about the stock market. All in all I therefore assign a low 10% to 20% probability to this actually affecting markets in a significant way. I would put a max of 5%-10% in below sub-portfolio for the duration of Trump’s obsessive focus on trade imbalances.

Portfolio construction: risk-off, commodities and trade shielded equities

  • I constructed a portfolio consisting of 5 ETFs, focused on dealing with a China-US trade war without positioning too specifically for how that would play out. This portfolio is 30% long US and China small caps, has 45% classic risk-off assets such as long JPY and US Treasuries, while the remaining 25% is put into inflation-sensitive commodities
  • The below table shows the portfolio characteristics. We are looking at a dividend of 2.3%, while the volatility is estimated to be 6.0% on an ex-ante basis
CategoryNameIDTERAlloc %
US Small CapiShares Russell 2000 ETFIWM0.20%15.0%
China Small CapGuggenheim China Small Cap ETFHAO0.75%15.0%
Long JPYETFS Long JPY Short USD ETFLJPY0.39%30.0%
US TreasuryiShares 7-10 Year Treasury ETFIEF0.15%15.0%
CommodityiShares Commodities Select Strategy ETFCOMT0.48%25.0%

Risk, diversification and allocation

  • Risk level: high
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 10%-20%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 2.30%
  • Ex-ante predicted volatility: 6.0%
  • 1 year 95% Value-at-Risk: –8.3%
  • Scenario: 2008 Lehman Brothers default period: -12.0%
  • Scenario Interest rates +100bps: -0.9%
  • Scenario 2008-2009: -5.7%
  • Scenario 2010 onwards: +87%


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How to Protect your Investments During the Next Market Crash

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
CategoryNameIDAddedUpdatedTERAlloc %
GoldSPDR Gold SharesGLD03/2018-0.40%50.0%
Defensive equityGuggenheim Defensive EquityDEF03/201804/20180.60%0.0%
Defensive HY creditiShares Edge HY Defensive BondHYDB03/2018-0.35%12.5%
US TreasuryiShares 7-10 Year Treasury Bond ETFIEF03/2018-0.15%12.5%
Long JPYETFS Long JPY Short USD ETFLJPY03/2018-0.39%12.5%
Defensive equityiShares Edge MSCI Min Vol Global ETFACWV04/2018-0.20%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%


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Preparing your Portfolio for a Hard Brexit

At 29th of March 2019, the United Kingdom is meant to exit the European Union. Whether the “Brexit” will be a soft one or a hard one has been on everyone’s minds ever since the 2016 referendum was narrowly won by those who wanted to leave the EU.

Since the day of the referendum, British asset prices have gyrated. The British Pound Sterling dropped from 1.50 right ahead of the referendum to close to 1.20 at the start of 2017, since recovering back to around 1.40. Similar numbers were seen for UK government bond yields, while UK stocks have been on a generally upwards trajectory.

In case of a soft Brexit, expect more of the same and no further big shocks, though with some sectors faring better than others and some outright profiting from the new dynamics. In case of a hard Brexit however, brace for volatility in any UK related assets.

First things first: what dates matter for Brexit?

The key dates in the Brexit process to keep in mind are the following ones:

  • March 2018. Target date for agreeing on a transition dea
  • April 2018. Target date for trade negotiations to start
  • October 2018. Target date for agreeing on a withdrawal treaty
  • 29 March 2019. Britain exits the EU and the transition period starts, possibly lasting all the way to the end of 2020

What are the risks and opportunities of a hard Brexit?

Whether in the longer term Brexit is a good or bad thing for both the European and British economy is still very much open for debate. Clearly the markets were not happy on the day of the referendum itself, but given that assets like GBP, UK GILTS and equities have either strengthened or at least undone much of the damage since then, it’s not unfair to say that an ambitious free trade deal – which is currently being aimed for on, as one presumes, both sides – would soothe many longer term concerns for the British economy. Currently a soft Brexit is being priced in.

What is also sure however, is that markets do not like surprises, and currently a hard Brexit would firmly fall into that corner, despite it being frequently talked about. On a macro level, a nasty Brexit surprise or an outright hard Brexit announcement anywhere between now and March 2019 would mean an instant weakening of GBP against all of the majors but predominantly USD, JPY and EUR. It would also lead to gains in UK GILTS and US Treasuries, while emerging market currencies may suffer as part of the stereotypical flight to quality. But any moves not directly related to the UK are likely to be short-lived, if June 2016 and other similar stress events are any guide for the future.

Assets to avoid in case of a hard Brexit

UK stocks with mostly domestic exposure. UK stocks with mostly domestic exposure will not do well if economic conditions deteriorate, while UK stocks with large EU exposure would be hard hit. Agriculture, services and manufacturing are simply best avoided

UK Property. If demand for commercial real estate falls as global business vacate the UK for continental Europe, property prices and REITs will naturally drop.

GBP vs majors. Pound Sterling is likely to weaken against USD, EUR and JPY in case of a hard Brexit

So what should you invest in?

UK stocks with non-EU international exposure. Stocks with significant international but non-EU exposure will be expected to do well in case of a hard Brexit and weakening GBP.  Examples are the mining and telecom sector.

UK GILTS. GILTS are seen as a safe haven asset, and post the Brexit referendum went up in value as rates declined. If that trend persists you will see the same thing, with subsequently things moving back to the way they were. Of course, if the Brexit news is sufficiently bad you could see the UK’s safe haven status being put to question, but no one really foresees that.

European financials. with banks, asset managers and insurance companies potentially moving jobs and activities out of the UK into continental Europe, and some competitors potentially not being able to serve the mainland anymore from London, European financials may gain new business.

How likely is this theme to play out?

I’d say the chance of a hard Brexit at the moment is somewhere between 25% and 50%. I actually reckon that most people underestimate the probability of this happening. If you are a British investor I’d say the key thing you need to do is diversify internationally as much as possible.

If you’re a non-British investor the safest thing may be to stay away from British assets as a whole. Why run the risk? If however as an international investor you want to position for UK assets that should be able to weather the hard Brexit storm, below portfolio will meet your requirements. I’d allocate anywhere between 0% to 5% to this theme and hold on to it until mid-2019.

Portfolio construction: long mining/telecom, Europe financials, GILT, short GBP

  • The hard Brexit portfolio contains British mining and telecom stocks, as these have relatively little UK exposure and thus would benefit most from a weakening GBP
  • European financials should benefit in case the position of the City of London weakens, while GILTS will strengthen as a safe haven. While other safe havens will likely mean revert, GILTS could be expected to stay at the stronger levels for a while longer
  • As all of these assets except for European financials are GBP denominated, you’d have to hedge out some of the currency risk. The short GBP ETF serves this purpose (ideally you would use a derivative such as an FX forward here instead so that it doesn’t eat up cash allocation, but this does the job too)
CategoryNameIDTERAlloc %
Short GBPETFS Short GBP Long USD ETFSGBP0.39%30.0%
UK mining stockBHP Billiton PlcBLT-20.0%
UK mining stockGlencore PlcGLEN-12.5%
UK Telecom stockVodafone PlcVOD-12.5%
UK GILTSiShares Core UK Gilts UCITS ETFIGLT0.20%10.0%
European financialsiShares MSCI Europe Financials ETFEUFN0.48%10.0%
UK telecom stockSky PlcSKY-5.0%

Risk, diversification and allocation

  • Risk level: medium to high
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 25%-25%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 2.45%
  • Ex-ante predicted volatility: 10.0%
  • 1 year 95% Value-at-Risk: –15.1%
  • Scenario: 2008 Lehman Brothers default period: -15.3%
  • Scenario Interest rates +100bps: +4.4%
  • Scenario 2008-2009: -7.7%
  • Scenario 2010 onwards: +49%
  • Scenario Equity up +10%: +9.6%
  • Brexit replay (23 June 2016): -3.7%*
  • Brexit replay (23 June-23 July 2016): +0.9%*
  • Brexit replay (23 June-23 Sep 2016): +5.4%*

* European financials were hard-hit, as were Sky and PLC (all returning worse than -11% on the day). My premise behind all of the above is that in case of a hard Brexit, over the longer term the benefits to these holdings would become apparent. In the second longer Brexit scenario this becomes apparent.


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How to Invest During a Period of Rising Interest Rates


  • To deal with rising interest rates, I propose a portfolio that consists of 50% stocks, 10% emerging market bonds*, 10% floaters and 30% in various short term bonds, of which mostly corporates with higher yields
  • Avoid long duration bonds, and take selective exposure to higher yielding short term and floating rate instruments to maintain fixed income exposure, yet adding a yield cushion to offset duration negative returns. I would also advise to steer away from gold, commodities, REITs and inflation linked bonds (unless, of course, the rising rates are entirely driven by inflation and central banks are chasing after the facts, but that currently does not seem a likely scenario)
  • Stocks and high yield corporate bonds will be expected to perform well in the initial rate hiking cycle, though care needs to be taken once the business cycle starts moving against them and interest rates potentially reverse, at which point you will want to shift from short-term bonds to longer maturities, and reduce your risk asset exposure. The portfolio at hand will work well until that moment

* for anyone questioning this based on conventional wisdom that EM will sell off during periods of rising rates (e.g. taper tantrum 2013), consider that between July 2016 and February 2018 US 10 year interest rates increased by nearly 1.6% (1.36% to 2.95%). In the same period the JPMorgan GBI-EM Global Diversified returned +11.9%. Naturally there will be short term volatility but I am proposing a portfolio that will see you through this event for the medium term.


Between 2009 and 2015 the US Federal Funds Target Rate seemed to be perennially stuck between 0% and 0.25%. Monetary conditions have been gradually tightening since then, and as of writing, US rates have reached 1.5%, though imminently to be raised yet again. Even some European interest rates have been slowly zigzagging their way up as economic prospects improved, and both monetary and structural trends should be expected to speed things up sooner or later as well.

Back in the US, the market currently expects anywhere between two and four more (25bps each) hikes this year, as well as a further two in 2019, by when short term rates thus could be as high as 3%. In the meantime long-term rates have been following their own path, with the 10 year yield largely stuck between 1.5% and 3.0% (and the occasional spike upwards like the 2013 taper tantrum of the Q4 2016 “Trump trade”). It is currently testing the upper boundary of that range.

Low interest rates made for ample liquidity and affordable borrowing, aiding economic growth and the stock market (which is still in the midst of a now nearly decade old bull market as of writing, though facing some headwinds recently) as equities were more attractive than most other investments. What will happen to the stock market if we take that catalyst away? And how will the various types of bonds respond?

Extent of hikes will depend on the US economy

Much of the extent and speed of future hikes will depend on how well the economy does: in particular job market and inflation dynamics and how fiscal stimulus and talk about tariffs on Chinese technology and global steel affects both.

It will also depend on how the Great Unwinding will play out: we are at the start of the unwinding of Quantitative Easing and Fed balance sheet reduction, which will drain liquidity from the system and very likely put downwards pressure on US treasuries and upwards pressure on US interest rates. In fact, some of the current conditions are reminiscent of those that could cause stagflation.

Then there is the question of international capital flows (does the PBOC keep buying treasuries, at what time does a 3%+ yield for AAA become irresistible for sovereign wealth funds, central banks and the like) and the risk environment (risk off markets tend to increase appetite for treasuries).

So what’s next simply isn’t very clear cut and only partly controlled by the Federal Reserve. Most agree though that bar some unexpected economic headwinds or a geopolitical shock event, short-term rates will keep trending up for near term maturities, but what happens on the longer end of the curve is less certain.

However, what is certain is that should rates indeed rise further, that will practically affect every other type of financial asset. In some cases directly, in others indirectly. Here we outline how to position your portfolio for such a rising rates environment. In fact, the below portfolio should be largely immune to shocks in interest rates, and be expected to perform well in all monetary conditions.

But structural issues could also push yields higher

In the short term economic conditions may be expected to push rates higher, but what about structural issues? An ageing population could mean a reduction in savings, which some say will push yields higher (in a reversal of the trend lower that it has caused over the last decades) while others point at the fact that this trend reduces the labor force growth, bringing down economic growth and interest rates in the longer term.

Another school of thought says that technology is responsible for low inflation which could keep interest rates down for longer. Economists are divided, it appears. Perhaps structural issues are best ignored when making changes that should help your portfolio get through the next year or so.

Business cycles, shape of the yield curve and key rate duration

As yields press higher, there has been a bit of noise lately about the shape of the yield curve. The Fed is able to directly manipulate the short end of the curve, but the longer end of the curve is driven by forces of supply and demand driven by economic expectations, and that longer end has been staying in place. That is what would be expected to happen when market participants foresee a recession coming up.

One statistic to be aware of in relation to this is Key Rate Duration. This is a metric that measures sensitivity of your portfolio to every point of the yield curve (2 years, 5 years, 10 years, 30 years, etc.) and can tell you how much a portfolio stands to gain or lose.

By rule-of-thumb math, a bond with a duration of 20 years may lose as much from a 0.05% change in interest rates, as a bond with a duration of 1 year from a 1.0% shift. That may be important to keep in mind once the economy starts turning, in order to properly weigh the trade off between short term and long term bonds in your portfolio.

Assets to avoid in periods of rising interest rates

  • US Treasuries: Interest rates go up, treasuries go down. Basically yes, but it’s not quite that easy: that Treasury Bills (the shortest term notes) will decline is a given, but how longer maturities respond is less certain and will depend on longer term economic expectations: are we getting stagflation (short term bonds get hit, longer term bonds relatively less so) or are we getting reflation (longer term bonds are especially hard hit)?
  • International government bonds and currencies: There is some degree of correlation between interest rates globally. Ceteris paribus, rising US rates will cause money to flow into the US from the rest of the world, weakening other currencies and requiring central banks to respond in kind. In the current situation where monetary policy in Japan and the Eurozone is still very loose, we would expect dollar strength and for global government bonds to underperform. Emerging market bonds may offer some reprieve through their higher yields (see below).
  • Real Estate Investment Trusts: This will largely depend on the pace of rate hikes. If they come fast and furious, dividend payouts will likely to be reduced as the cost of debt financing increases, leading to declines in REIT prices (partly offset by their high yields).
  • Inflation Linked Bonds: Bonds where the principal is indexed for inflation. As rising rates will tend to go along with rising inflation, these could in theory be the perfect hedge. But their returns above inflation may still be meagre, and if rates go up without rising inflation (as may be the case with the Fed balance sheet unwinding), you would still wind up with losses. Potentially large ones if the (nominal) duration is significantly long.
  • Commodities: In general, rising interest rates would apply downward pressure on precious metals like gold as their relative attractiveness declines. Meanwhile, oil and energy commodities could sell off as the dollar strengthens (capital flows in due to the relatively higher yields), which makes purchases by foreigners more expensive.

So what should you invest in?

  • Short Term Bonds: The duration (interest rate sensitivity) of short term bonds is lower than long term bonds. If you buy a 6 month note at a 2% yield today and rates move to 3%, you will at most miss out on several months of the higher yields. Price changes won’t be an issue as bonds mature at par. For bonds with longer maturity, the general rule of thumb that each additional year of duration leads to an additional -1% loss for every 100bps increase in rates should be kept in mind.
  • Corporate bonds: Credit bonds offer a higher yield above treasuries which cushions the blow in cases of rising rates. You will want to keep the maturities short (say 1-3 years) as their interest rate risk minus the credit spread will still be the same as treasuries. Also, high yield (junk) bonds will tend to be less affected by rising rates than investment grade bonds, but obviously come with higher risk. As AllianceBernstein points out however, credits may do well at the start of a rate hiking cycle, but may be less attractive towards the tail end of it.
  • Floating rate notes and senior bank loans: (Investment grade) Floating rate notes are usually corporate bonds that typically pay a spread above a reference rate, e.g. LIBOR+100bps. That rate is reset on a regular basis, meaning that if rates rise your coupon receipts keep getting adjusted and you are protected. The downside is of course that if rates decline from here, your yields are going right down the drain with them. Bank loans can be similarly attractive but are less liquid, have lower credit quality and may be callable, so I’d avoid them.
  • Stocks: When rates go up, dividends become relatively less attractive than bond yields which should normally put downward pressure on stocks. Moreover, rising rates will at some point cut into corporate profits which would immediately have a negative impact on companies’ balance sheets. The point at which this starts to happen is hard to discern, but many economists reckon the long term average should be 3% to 3.5%. On the other hand, in the initial stages rising rates also signals confidence in the economy, which should boost stocks and especially cyclical ones. As with REITs, the impact on stocks is likely to be correlated with the pace and extent of the rate hikes, where gradual is good, while fast and abrupt is bad. Financial stocks should do well (as the yield spread between borrowers and savers widens), and consumer discretionary, industrials, tech and materials (i.e. cyclical stocks) would generally hold their ground too.
  • Inverse bond ETFs: Inverse bond ETFs are leveraged products that deliver you the opposite returns of bond ETFs. If rates rise, you can profit at either 1x, 2x or 3x leverage. If higher rates are on their way, in principle you’d want to invest all your money in products like this, but the leverage component adds an extra risk factor and it’s very important to note that these products only deliver the returns that you would expect on single days, not over longer periods. I personally am not a big fan of these products. Take TBF (Proshares Short 20+ Year Treasury). At an estimated duration of 17, by rule-of-thumb math its return should
  • Long US dollar: the dollar would be expected to strengthen as rates go up. Never mind that as of writing the opposite is actually happening, but that appears to be driven by other forces (one of which is a strengthening euro), and over longer term rising rates = stronger US dollar remains economic orthodoxy. At the same time, much will depend on what other central banks do (the ECB and BOJ are still applying quantitative easing, should that change in the near term the picture may change). For non-US based investors, having some long dollar exposure will nevertheless be a good idea.
  • Emerging Market Bonds (Local Currency): This is kind of the opposite of the previous point, but emerging markets are in much better shape than in previous periods of rising rates and dollar strength, so their currencies are more likely to hold (some of) their ground. Moreover, yields of around 6%-7% on certain markets help to make up for any drop due to FX and rate changes, and if you pick countries with healthy current account balances you’re also more likely to end up with a more stable investment in the face of rising US interest rates.

Portfolio construction: equity, short term bonds and high yields

  • The below portfolio would be able to stomach rising rates and should be able to deliver a decent return throughout such periods. The allocation is 50% stocks/50% bonds, you can choose to scale this up or down commensurate with your own risk appetite
  • Within stocks we don’t distinguish, while bonds focus on shorter term and a good portion of higher yielding assets (high yield bonds and EMD). As rates at some point start to peak (look for the 3% to 3.5% range) you can start to shift into longer duration bond ETFs and reduce the stock allocation
  • The portfolio characteristics are shown below. The predicted volatility is 5.3% and according to our risk model, this portfolio is expected to deliver outperformance during both positive markets for equities (+6.8%), as well as in a period of strongly rising rates (+2.0%).
  • Note that this portfolio is not a directional “bet”, if rates do not rise but move the other way you would still be able to do well, there are yield generating assets included in the portfolio in both the fixed income and equity portion.
CategoryNameIDTERAlloc %
StocksVanguard Total World Stock ETFVT0.10%50.0%
Short Term BondsVanguard Short-Term Bond ETF
Corporates (ST)SPDR Portfolio Short Term Corporate Bond ETFSPSB0.07%10.0%
HY Corporates (ST)SPDR Barclays Short Term High Yield Bond ETFSJNK0.40%10.0%
Floating Rate NotesiShares Floating Rate Bond ETFFLOT0.20%10.0%
EMD Local CurrencyiShares J.P. Morgan EM Local Currency Bond ETFLEMB0.50%10.0%

Risk, diversification and allocation

  • Risk level: low
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 75%-100%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 2.10%
  • Ex-ante predicted volatility: 5.3%
  • 1 year 95% Value-at-Risk: –8.1%
  • Scenario 2008 Lehman Brothers default period: -12.4%
  • Scenario Interest rates +100bps: +2.0%
  • Scenario Equity up +10%: +6.8%
  • Scenario 2008-2009: -8.2%
  • Scenario 2010 onwards: +77.6%


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