How to hedge against uncertainty

Gold and precious metals remain the best assets to face market uncertainty, as demonstrated in the past with the global financial crisis and again recently with the UK decision to leave EU

With the Fed less likely to hike rates, the upcoming US presidential election, UK leaving EU, the ECB adding more stimulus to support EU economies and China struggling to meet growth expectation, 2016 has been so far a challenging year for investors. News and rumours are dictating market movements across the board. Asset classes are moving in tandem as challenges reshape the world. In such a volatile environment, short term tactical trades are favoured with investors forced to review their allocation strategies more often than intended.
In this note, we show the best and worst performing assets under different scenarios based on manufacturing production, inflation and leading indicators. We also look at how to use these assets in a portfolio as a hedge or to outperform.

Gold and precious metals – the best assets to face uncertainty
Contrary to evidence from electoral polls, the shocking EU Referendum result for the UK to exit the Union sent financial markets into a panic. Investors need to be able to hedge their portfolio against shocks where assets across the board are sold off aggressively due to unexpected events.
We looked at how each asset class performed six months following three recent financial crises: the global financial crisis, the Arab Spring and the Chinese market closure.

The above chart shows that gold and precious metals remain the best assets to hold in a portfolio during periods of high market uncertainty. After each market shock, gold returned 21%, 22% and 24% (non-annualised), while a precious metals basket returned 15%, 30% and 23%. Bonds also tend to perform well during these periods.

Stocks with resilient earnings – a protection from the downside
The future of the UK and the EU is adding to global financial market uncertainty, which could in turn impact economic growth. Which assets stand out in periods of slowing growth?

The above chart shows the best and worst performing assets during periods of slowing global manufacturing production.
The returns represent the average monthly returns of assets during the months where global manufacturing indicators were at the lowest over the past ten years.
Stocks with resilient revenues such as energy MLPs,
Cybersecurity or small caps tend to perform best because of the nature of their businesses. Clients of midstream MLPs tend to sign contracts over the long term while demand for niche businesses such as cybersecurity tend to be inelastic to price and non-cyclical.

Combining inflation and growth indicators
In this section, we are analysing assets performance under four different economic scenarios that combine global inflation and growth.
As summarised in the below table, we observed that during periods of slowing growth, energy MLPs and cybersecurity perform well regardless of inflation.
China and EM stocks, as well as robotics are ranked among the top ten performers during low inflation periods regardless of global growth, while EM bonds are ranked sixth in a high inflation and slowing growth environment.
Agricultural commodities are more concentrated in the bottom right of the table where inflation is high and growth is rising.
Metals with industrial applications benefit most from a rising growth environment regardless of the inflation dynamics, while gold performs best in high inflation periods alongside slowing growth.

Looking at the table, it is interesting to note that US small cap stocks are ranked among the top ten performers in three out of the four scenarios, the exception being in growing manufacturing production and high inflation environment.

The case for small caps
Based on the previous scenario analysis, we have devised a relative trade strategy between small caps and large caps and analysed the impact on the portfolio’s risk/return profile.
In our analysis, we use a portfolio of 60% global large caps and 40% global bonds as our benchmark and we use an in-house global leading indicator as a trade signal. When the global leading indicator is rising, signalling an economic expansion, the portfolio allocates the 60% equity component into small caps. When the global leading indicator is declining, signalling a slowdown in economic growth, the portfolio re-allocates the equity component into large caps at 60%.

The above chart shows that the relative trade portfolio with small caps replacing large caps during expansionary periods outperformed the benchmark by 35% over a period of 17 years, posting an information ratio of 0.6.

The relative trade portfolio strategy also enhances the Sharpe ratio from 0.42 with the benchmark to 0.58.

Edith Southammakosane – Multi-Asset Strategist – ETF Securities