Investors should shape strategies that protect against the downside, said Jeff Gardner, senior portfolio strategist, Bridgewater Associates. Speaking at the Fiduciary Investors Symposium at the Chicago Booth School of Business, he said that investors should prioritise protecting against losses in the current environment: increasing returns can be additive to long-term wealth, but missing the big losses is just as important to driving long-term wealth creation. Strategies using put options that protect against downside outcomes can help raise the consistency of returns and lower volatility.
In an environment where it isn’t clear which, if any, asset will be protected, reducing downside outcomes is a powerful tool. Even if two different assets have the same return over a long period of time, the asset with less risk will give more wealth because it avoids the losing periods.
Put options protect against drawdowns, but often at a cost that outweighs the long-term benefits. He suggested a strategy that offers downside protection but also positive returns when equity markets are performing. He said put options can protect investors in the peak to trough of equity falls, offsetting declines, adding that options premium is at its highest after the decline in markets making protection expensive.
The strategy offers investors a diversifying solution in a market environment where few assets look truly diversifying. Every asset has a bias and performs better – or worse – in a particular environment. Biases amount to inconsistent returns and have led to classic strategies like holding diversifying assets or creating overlays that hedge exposures – for example hedging liability risk by overlaying with duration.
The challenge today, however, is that there is little option to diversify. Traditional assets can provide some level of diversification, but it is possible that all assets suffer at the same time and bonds may not provide traditional diversification.
“Everything can go down and there is very little that can protect you,” he said. Gardner warned, however, that moving away from structural diversification to tactical strategies comes with timing risk.
Looking back
Gardner set the scene by outlining the causes of the current economic climate. The decline in inflation and historically low interest rates over many years has driven financial returns – returns that have also been fuelled by globalisation. In another trend, returns over the last decade have gone to capital and not benefitted labour.
“Political pressure is changing this,” said Gardner. He also noted how assets in underlying portfolios have outperformed their underlying economies.
Central bank stimulus in response to the pandemic has been highly inflationary and equivalent levels of stimulus have only ever been seen in war time.
“We combated the Covid war with a war time policy: this cycle is now playing out” he said. He noted that US household wealth increased during Covid, creating a nominal demand which supply couldn’t match, making the economy vulnerable to shocks – like war in Ukraine and Covid’s resurgence in China. The large stimulus to cushion the impact of Covid on less fortunate households was important, yet he added that the Fed could have pulled back on the stimulus earlier.
Gardner said policy makers are in a tough spot, caught between trying to support growth and bring inflation down yet unable to accomplish both simultaneously. It leaves investors focused on mitigating risks – and holding onto how well assets have done recently.
The future
Reflecting on what the Fed might do next, he noted that a small tightening – enough to bring inflation down – is priced in by markets. However, equity markets have not priced in any adjustment to earnings: the drop in equity markets is so far due to rate rises.
Gardner said that European economies, hit by the loss of Russian energy, are most likely to experience stagflation and shared concerns of a food crisis in northern Africa that could kick off further unknowns. He noted the bifurcation in equity markets, where the US has outperformed Asian and European indices, could signal opportunities in Japan and China and urged investors to hold more real assets. He noted how investors have been unwilling to hold real assets because they have dragged on portfolios, and have historically under allocated to real assets compared to financial assets. He advised investors to focus on the cash flows in their investments, warning that cash flows in real estate may not offer inflation protection.
Western economies are balancing tightening with weak growth, but other economies, like Japan, don’t have the same inflation problem. He added that emerging markets also look cheap. Elsewhere delegates noted that gold has not reacted to market turmoil, despite rate cuts and the dollar strengthening.
“Gold is underperforming and it’s interesting it hasn’t had a bump [up] from crypto selling off,” said Gardner.
Looking ahead, Gardner said China’s Covid challenge (where low vaccination rates among the elderly and less effective vaccines prevail) has been priced into supply chains. He said that moving from a zero Covid strategy in China carries risks, and shifting to effective vaccines is not a short-term fix. Still, China is now focused on finding the right policy mix to support growth, and has the tools to ease interest rates and allow the currency to weaken.
He said that Bridgewater has predicted more downside than has yet occurred, missing the forces that led to the continued extension, and the willingness of the Fed to keep stimulating the economy. However given today’s inflation levels he concluded:“It does finally look like a turning point.”
