- Wednesday, December 5, 2018
At certain points in a market cycle, usually when a down turn is looming, investors consider the defensiveness of their portfolio. We still feel that equities have an opportunity to make some additional end of cycle growth but this is expected to become a diminishing virtue. The question now is how to protect capital and reduce volatility while still making positive returns. In a low-yield slow growth economy this is challenging.
Defensive investing tends to work best as a tactical strategy. One that is temporarily helping a portfolio to weather a period of unfavourable conditions at a particular point in an economic cycle as the growth phase ends. However, if a defensive strategy is maintained for too long a period due to over caution, it will weigh on a portfolios long term growth potential.
With this in mind, we are reducing portfolio risk across our portfolio range in order to defend capital from the growing number of global uncertainties and challenges. We are also still holding meaningful levels of equity in the desire of capturing capital growth.
Cash is the ultimate defensive asset but it does come at a cost, particularly if inflation is rising, and purchasing power and capital growth is lost. It therefore does not pay to be in too much cash for too long. Capital is best put back to work as soon as the outlook improves and catches the new upward momentum.
Short duration corporate bonds are a level of risk up from cash but can add a defensive layer. They are less effected by rising interest rates as compared to longer duration bonds and offer fixed interest returns.
The correlation between bonds and equity has been challenged by the financial crisis and quantitative easing programmes. Both fell during the financial crisis and both rose in the recovery. The traditional bond to equity splits do not offer the same negative correlation protection as they once did. It would still be expected that gilts should provide non-correlated diversification from a falling equity market.
Gold traditionally outperforms in inflationary conditions and is a safe haven asset in times of equity losses. The overheating US economy is fuelling the need for inflation protection. The fact that gold produced no return and has been falling in value as the US dollar has strengthened in value has meant we have avoided holding the metal until the end of the growth cycle when its characteristics become more attractive.
When markets are rising, no one wants to forgo upside gain to protect against an event that may not occur, but if it does investors will be grateful. The balance of probability weighs more heavily on further market volatility until the main issues of interest rates, trade wars, Brexit, quantitative tightening and stable oil pricing are resolved.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.