Why bonds are now the better hedge
This is not a year in which investors have needed to hedge their equity risk. As of this writing, stocks have not only rallied, they’ve rallied with a consistency last seen in 2017, at least until the last day of July and the first of August.
But as investors look to protect gains and seasonal patterns turn less favorable, many investors are reconsidering how to best insulate a portfolio. Back in June, I discussed three potential hedges: yen, gold and U.S. Treasuries. Gold and long-duration U.S. bonds have done particularly well since then, up 8.5% and 4% respectively. Going forward, however, I would lean more into Treasuries as a hedge against equity risk. The main reason: the dollar.
What are you afraid of?
As I highlighted in June and in previous blogs, no hedge works in every regime. When growth slows, bonds are normally effective. However, bonds are less additive, even counterproductive, when the source of equity market volatility is inflation. In addition, some hedges, notably cash, are reliable but not very convex. In other words, while cash does not lose money when stocks sell off, it also does not appreciate. Where does this leave investors today?
With inflation subdued and central banks generally turning dovish, the biggest risk for most investors is growth and the risks to the expansion. Not helping matters are the President’s latest tweets. An escalation in trade frictions has the potential to further undermine business confidence and investment. If events move in this direction, bonds are likely to prove the more effective hedge.
While today bonds are less negatively correlated with stocks then was the case in December, correlations remain decidedly negative (see Chart 1). With growth still decelerating and the economic risks to the downside, Treasuries are likely to continue to rally if growth estimates fall further.
The challenge for gold is that it is a less reliable hedge. Its efficacy depends not only on growth and interest rates, but critically also on the direction of the dollar. To the extent the dollar rises on trade frictions, this is likely to undermine its efficacy as a hedge.
The bottom line
I would keep some gold in the portfolio, as its volatility can work in your favor during risk-off periods. That said, I would rely more on safe duration, i.e. U.S. Treasuries. Not only is it a source of income, but it is arguably the more reliable hedge if the trade war escalates.
To be clear, U.S. Treasuries have their own challenges, with long-term yields roughly 140 basis points (bps, or 1.40%) lower than last November. As a result, Treasuries are less attractive as a source of income. That said, they are still likely to prove more attractive as a source of portfolio protection than the alternatives.