Category: Macroeconomic

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 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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