Preserving capital in the ‘Everything sell-off’

2022 has revealed pressure on a range of financial instruments, not just equities, and the need to identify consistent capital preservation assets has become critical. GAM Investments’ Julian Howard considers the role tighter monetary policy may play in offering at least a part-solution for investors.

11 July 2022

George Bernard Shaw once said, “No question is so difficult to answer as that to which the answer is obvious.” He may not have been thinking about how investors can protect capital when everything is selling off simultaneously as it seems to be today, but the challenge for investors is so pressing that any insights into how they might identify a solution would surely be welcome.

First it is worth considering why the ‘everything sell-off’ is such a pernicious problem for investors. Constructing managed investment portfolios typically involves an in-depth suitability review at the outset which determines the investor’s risk appetite and time horizon, which are then mapped to the returns that can be reasonably expected from capital markets. While those investors with an inter-generational outlook will conclude that a global equity portfolio is the best way to proceed given the inherent growth qualities of the listed corporate entity, many others have investment goals that need to be fulfilled within shorter time periods and so will settle on a combination of equities for growth complemented by a variety of capital preservation assets to dampen volatility along the way, even if this comes at the expense of lower overall returns. These capital preservation assets have traditionally comprised bonds, including government paper and credit, as well as alternative investments, including hedge funds such as equity long/short managers, and gold or more recently bitcoin.

Normally, a well-diversified capital preservation book would not be sucked into equity market drawdowns but this time around, all assets have a common nemesis in the form of slowing growth, inflation and correspondingly higher interest rates. In a seminal 2003 paper titled ‘Stock-Bond Correlations’, Antti Ilmanen concluded that “inflation shocks tend to cause common discount rate variation across asset classes.” In other words, as central banks (mistakenly in our view) tighten policy in response to rising inflation, this reverberates across all financial assets. This is because said financial assets are at their heart claims on future cashflows and their net present value – or price – must be determined using a prevailing discount rate. Hence the phenomenon of the ‘Everything Rally’ up to 2021 turning into the ‘Everything Sell-Off’ in 2022 (see chart below).

While the effect of higher rates is arguably most pronounced in equities, we believe this asset class should nonetheless hold a structural place in a portfolio because its performance, which tends to be stronger compared to other assets, accrues over very long time periods and can be compromised by excessive adjustments. However, capital preservation assets designed to consistently diversify from equities may find themselves simply unable to fulfil their roles during specific market environments such as are being witnessed today. As inflation expectations have risen and fears of a recession have grown, the 10-year US Treasury note and Bloomberg US Corporate High Yield index have fallen -14.1% and -13.1% year to date to 21 June 2022, respectively.

The ‘Everything rally’ gives way to the ‘Everything sell-off’:

For investors considering alternatives to these traditional but now underperforming diversifiers, much would seem to hinge on the future path of inflation. Debate currently rages between regime changers on the one hand who believe that we are on the cusp of a new high inflation, high rates era, and ‘Team Transitory’ and associated secular stagnationists on the other hand who believe that after an interregnum period – say 12-18 months – the familiar trinity of low growth, low inflation and low rates will reassert itself. Regardless, central banks are not hanging around to find out which side will prove correct. After the recent 75 bps US rate hike, Federal Reserve (Fed) Chair Jerome Powell asserted, “My colleagues and I are acutely focused on returning inflation to our 2% objective”. This echoes sentiment from European Central Bank (ECB) President Christine Lagarde, while the Bank of England – perhaps with less outward enthusiasm – has begun its rate hike cycle. Two-year government bond yields have historically provided a fairly accurate guide to where interest rates are likely to end up across the three economies (see chart below). In all three cases, there is some way to go. This ongoing upward adjustment to the discount rate presents a continuing challenge for all assets. Setting equities aside as discussed, we believe the focus now should therefore be on reassessing allocations to those areas of the capital preservation complex which are more vulnerable to inconsistent returns until the inflation issue resolves itself.

Where the rate cycle might end (hint: we’re probably not there yet):

But then the question is where to reallocate to? One potential solution to the problem lies hidden in the midst of the problem itself. If that sounds counterintuitive, just take a look at the 3-month US T-Bill, for example, a short-dated government debt instrument that closely tracks the current US Federal Funds discount rate. At the end of 2021, it barely yielded three basis points, but by late June it was yielding over 1.5% and, if the predictive power of the 2-year US Treasury bond yield is any guide, it could end up yielding over 3% in the coming months as interest rates are hiked further. Adjusted for inflation of course, this yield is not so impressive but given the near impossibility of reliably protecting against inflation in the short to medium term, it remains highly useful for protecting nominal capital in a multi-asset portfolio, in our view. Over the 12-month period ended 21 June 2022, the 3-month T-Bill has returned 0.3% with a volatility of 0.1%, representing both a much better absolute return but also a better risk-adjusted return than diversification stalwarts such as the Bloomberg US Aggregate Bond index (made up of government and investment grade paper), the HFRX Global Hedge Fund Index and gold. We think this performance disparity could grow even further as central banks continue to fight inflation with tighter monetary policy, potentially seeing the US T-Bill generating a 3% yield with almost no volatility by mid-2023. Though not yielding quite as much as the US T-Bill, equivalent instruments exist for UK and eurozone investors and the broad case for their use in portfolio construction remains the same, in our view.

As central banks grapple with the issue of inflation, the resulting higher rates may offer at least a part-solution to the continued volatility likely to be witnessed across most financial assets as future cashflows are priced downwards. While cash and very short-dated fixed income instruments have often been derided as not being ‘proper’ investments, in an environment where nearly everything looks vulnerable to further nominal capital depreciation in the short to medium term, allocating to them could be the most prescient decision an investor makes this year. Sometimes, the best solutions are just hidden in plain sight.