A Roadmap for Defensive Investing

Winding Road

While the 2019 market rebound has undone much of the damage from 2018’s year-end drubbing, the brutal selloff offers a key reminder for investors about portfolio management, specifically the importance of having defensive exposures.

The selloff from October 3rd to December 24th dragged the S&P 500 Index down by 20% and the Russell Small-cap index more than 24% (Source: Bloomberg). This was driven primarily by fears of continued rate hikes by the Federal Reserve, valuation concerns and worries about a global growth slowdown.

These large draw-downs are a far cry from the relatively quiet markets seen in recent years, which drove investors to seek exposures to pro-cyclical market areas such as momentum stocks or high yield credit. As investors adjust to a lower growth paradigm, investors may want to consider exposures that either offer limited downside protection such as minimum volatility strategies or that move less in sync with equity and bonds such as in commodities

ETF Flows

Indeed, investors are taking notice of the importance of defensive positioning. Even with the rebound in stocks this year, our research shows that flows into defensive exchange traded products are outpacing flows into all products as a percentage of assets under management.  U.S. listed fixed income ETFs have garnered nearly twice as much as equity flows year to date. Minimum volatility strategies are attracting the biggest flows this year among factors, gaining $5.78 billion, while momentum has seen nearly $0.6 billion in outflows (Source of flow data: Markit, BlackRock as of March 14, 2019.)

Building a buffer

Here are a few ways investors can add targeted defensives exposures to their portfolios.

1. Equities

Minimum volatility strategies historically have reduced risk in down markets compared to the broader market and Q4 2018 was no exception. The MSCI USA Minimum Volatility Index outperformed the S&P 500 Index by more than 600 basis points (bps, or 6%) in the fourth quarter of 2018. Min vol also worked well in other regions: The MSCI Emerging Markets Minimum Volatility Index outperformed the MSCI Emerging Markets Index by more than 900 bps in 2018.[1]It is worth noting that minimum volatility strategies historically have tended to perform well both in growth slowdowns and in outright recessionary market conditions. Investors may also want to consider high quality dividend paying stocks, which can offer potential income as well as some resilience in down markets as well as adding so-called “safe haven” countries such as Switzerland and Japan.

2. Fixed Income

The Federal Reserve has raised interest rates nine times since the tightening cycle began 2015. Investors, who were looking to take advantage of those hikes added exposures to short-term fixed income assets. However, with the market expecting just one more rate hike 2019, investors concerned with slowing growth or geopolitical turmoil may want to consider longer duration Treasurys (ten years or longer). Historically, these have offered some buffer for portfolios in serious market downturns, as well as a chance to potentially pick up some extra yield.

3. Commodities

Historically, commodities have tended to provide meaningful diversification and inflation hedging benefits.

Correlations

For example, from April 1991 to March 2019, the annual returns of the S&P GSCI Index have had just a -0.13 correlation to the US Treasury 10 year benchmark index and a 0.25 correlation to the S&P 500 Index.[2]

In addition, many commodity assets, such as gold, are priced in dollars, and historically have performed in line with an increase in inflation expectations. Therefore, they may serve as an inflation hedge in a portfolio. In the current environment we don’t expect a major increase in inflation, but holding inflation hedges.

Some may question where cash fits into a defensive portfolio: While investors generally hold relatively high levels of cash, as the BlackRock Investor Pulse survey has shown, this buffer is increasingly being reallocated to other high quality fixed income options such as U.S. Treasuries as a way to earn incrementally higher yield.

Let’s be clear: Seeing your portfolio decline in value is never fun, and losing less money than the market at large offers little solace. But over the long term, creating a buffer from the downswings – known as “downside protection” can add value to a portfolio.

There’s an old saying, “You should fix your roof when the sun shines.” We don’t expect a recession in 2019, we still believe stocks will continue to climb and we prefer them over bonds. But the kind of volatility we saw in the fourth quarter could reappear, the result of any number of unforeseen events. When or if that occurs, it would be wise to ready.

 

Chris Dhanraj is the Head of the iShares Investment Strategy team and a regular contributor to The Blog.

 

[1] Source: Bloomberg, as of 12/31/18.

[2] Correlation measures how two securities move in relation to each other. Correlation ranges between +1 and -1. A correlation of +1 indicates returns moved in tandem, -1 indicates returns moved in opposite directions, and 0 indicates no correlation.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes than the general securities market. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Investing in commodity-linked derivatives and commodity-related companies may increase volatility. Price movements are outside of the fund’s control and may be influenced by weather and climate conditions, livestock disease, war, terrorism, political conflicts and economic events, interest rates, currency and exchange rates, government regulation and taxation.

A fund’s use of derivatives may reduce a fund’s returns and/or increase volatility and subject the fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited.  There can be no assurance that any fund’s hedging transactions will be effective.

Diversification and asset allocation may not protect against market risk or loss of principal. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.  The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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Why Gold May Be Looking Cheap

The gold leaf. For the background and textures.

Of all the asset classes, commodities, particularly gold, are arguably the most difficult to assess. They are generally the most volatile. Moreover, the lack of cash flow makes them difficult to value; as a result, commodities tend to trade more on momentum. With that as a caveat, it is worth asking the question: Is gold beginning to look “cheap”?

I discussed gold recently in June and back in November. In both posts I suggested that gold would struggle with rising real-interest rates and a stronger dollar. The takeaway was investors should consider owning less gold than they typically would. While both rates and the dollar are still potential threats, according to one crude measure, gold prices may already reflect these factors.

Although commodities are notoriously difficult to value, there are ways to tease out an approximate range. As it applies to gold, one measure I’ve found useful is the ratio of the price of gold to the U.S. money supply, measured by M2, which includes cash as well as things like money market funds, savings deposits and the like. The logic is that over the long term the price of gold should move with the change in the supply of money.

Over the very long term this has indeed been the case. Gold’s value has risen, fallen and risen again, but over a multi-decade period gold and M2 have tended to move together. In other words, changes in gold prices have equaled changes in the money supply, with the ratio tending to revert to one. We can think if this as the long-term equilibrium.

Gold Money Supply Ratio

That equilibrium level is also relevant for future price action. When the ratio is low, defined as 25% below equilibrium, the medium 12-month return has been over 12%. Conversely, when the ratio is high, defined as 25% above equilibrium, the 12-month median return has been -6%. Today, gold is trading at a ratio of 0.73, i.e. 27% below the equilibrium level. This is the lowest point since late 2016.

Inflation is key

This measure can be refined further. Not surprisingly, gold tends to trade at a higher ratio to M2 when inflation is elevated. As many still view gold as an inflation hedge, investors are more inclined to buy when inflation is higher, particularly when interest rates are not keeping up with higher inflation.

U.S. inflation is still low by historical levels, but at 2.9% U.S. headline inflation is at its highest level since 2012. This supports the notion that gold looks relatively cheap. Based on this relationship, gold is approximately 10% undervalued.

Value, as I’ve said many times, is a poor short-time timing tool. To the extent the dollar continues to rise, gold is likely to struggle. That said, based on this metric gold is trading at the cheapest levels since the dollar last peaked in late 2016. To the extent it is even practical to discuss value and commodities in the same breath, gold prices are starting to look interesting.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

Investments in natural resources can be significantly affected by the events in the commodities markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2018 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

 

Don’t Fear the Commodity Slump—Yet

Aerial photo of the front end of a large fully loaded container ship.

So far it has been a great year—at least for paper assets. Long-dated U.S. Treasuries are up 4%, high yield 6%, the S&P 500 nearly 10% and emerging market equities over 17% in U.S. dollar terms. But it has been a less inspiring year for commodities.

Some investors are wondering whether softer commodity prices represent a sign of economic deceleration—along with a flatter yield curve and decelerating inflation—or an even bigger threat. For now, I think the answer is no. Here are three reasons why:

Commodities prices have witnessed significant divergence

Not all commodities have done poorly year-to-date. The weakness in some commodity indexes has been largely about energy. Oil prices are down nearly 20%; natural gas has done even worse. However, metals have performed better along with select agricultural commodities, notably corn and wheat.

2017 Asset Performance

The drop in energy has been as much about supply as demand

It is true that oil demand has slipped: The International Energy Agency (IEA) puts worldwide crude demand in the first quarter at 96.45 million barrels per day (bpd), down from over 97.60 million bpd at the end of 2016. However, compounding the problem has been a rebound in supply. Two OPEC countries in particular have surprised with higher production: Libya and Nigeria. Libyan production has quadrupled from last fall’s low, while Nigerian production has risen by more than 300,000 bpd since last August. At the same time, U.S. shale producers continue to demonstrate remarkable resiliency in the face of lower prices. U.S. domestic crude oil production has climbed by almost 600,000 bpd since late December and by nearly one million bpd from last fall’s lows.

Cyclical commodities are doing well on the manufacturing rebound

While precious metals are having a mixed year—gold up, silver down, platinum flat—industrial metals have generally been strong. The Journal of Commerce (JOC) Industrial Metals Index is up approximately 6% year-to-date. This is consistent with the global improvement in manufacturing surveys. For example, in the U.S. the Institute for Supply Management (ISM) Manufacturing Index has risen three points since December and is now close to a three-year high. Even more encouraging, the new orders component has been particularly strong. This is important as the level of new orders correlates closely with industrial metal gains. To the extent manufacturing surveys—and particularly new orders—remain high, industrial commodities are more likely to be supported.

For now investors can look past softness in commodity indexes. What would change my mind? Two things in particular would cause me to worry: a sharp downturn in leading economic indicators or substantially tighter financial conditions. For now, the former is not visible. On the latter, while the Federal Reserve is tightening and the European Central Bank is musing about less accommodation, financial conditions remain easy thanks to still low interest rates, a weak dollar and tight credit spreads. Should these conditions remain in place, investors can, for now, look past the challenges in the commodity sector.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Do Commodities Deserve a Place in Your Portfolio?

Gold

One of the bedrock principles of wealth management is diversification. Proper diversification can mean lower overall risk without lowering your portfolio’s potential returns. So alternative asset classes like commodities, which refer to everything from crude oil to wheat to gold, would seem to be a key tool in achieving this venerated idea of a fully diversified portfolio.

Yet commodities have been the worst-performing asset class so far this year, and their underperformance isn’t a short-term blip. Commodities have been trending downward for about 5 years and have fallen by more than 10% in 3 out of the last 5 quarters. Given these mediocre results, do commodities deserve a long-term allocation in your portfolio?

Unfortunately there’s not a simple “yes” or “no” answer to that question. Commodities don’t move in lockstep with more traditional investments such as stocks and bonds, so including commodities in a portfolio tends to increase the portfolio’s diversification. But commodities are also a very volatile asset class. Whether the additional diversification outweighs the high volatility depends on what else is in the portfolio and also what return commodities will provide.

Estimating what return commodities will provide, even over very long periods of time, is difficult. Since commodities are the inputs that go into producing the goods we use, it’s reasonable to expect commodity prices to rise roughly in line with the inflation rate over the long term. But commodity funds typically don’t hold physical commodities. They get exposure to commodities by buying commodity futures, which are financial products whose values are based on commodity prices.

Over the long term the returns from investing in commodity futures aren’t actually that closely tied to the changes in commodity prices. More esoteric factors, such as the difference between current commodity prices and futures prices and the returns from the bonds used as collateral when buying the futures, tend to be more important. In recent years, with the rise of commodity exchange traded funds helping to drive up futures prices and with the low interest rates that have persisted since the global financial crisis, the results from investing in commodity futures have been disappointing.

These two trends—strong demand for commodity futures from exchange traded funds and low interest rates—aren’t likely to disappear overnight, but they’re also unlikely to last forever. So at some point commodities will become a more rewarding investment than they have been in recent years. Yet given the intricacies of investing in commodities, making sure you understand exactly what factors will affect your investment’s performance is critical. Commodities can help diversify your portfolio, but in some cases the costs of that diversification outweigh the benefits.

How Long Will Low Commodity Prices Last?

Commodity Returns

Commodities as an investment haven’t done well in recent years, but this year has been especially bad. They’ve been the worst-performing asset class in 2014, with a return of -16% year-to-date. Barring a rebound in the next month and a half, that would be their worst performance since the financial crisis in 2008. So is the pain now over for investors with exposure to commodities? The answer depends on the key factors that have driven down commodity prices.

Perhaps the most important factor affecting commodities is the pace of global economic growth. Stronger economic growth translates into more demand for commodities, but the global economy has slowed as growth in emerging markets declines and the European economy continues to stall. While the global economy grew by more than 5% per year in the mid-2000’s prior to the financial crisis, it’s only averaged around 3% growth per year since 2012.

The good news for those hoping for higher commodity prices is that the global growth rate may partially bounce back. The International Monetary Fund projects that the global growth rate will increase to around 4% per year over the next few years, powered by stronger growth in the United States and emerging markets. There are a number of ways that such a potential rebound could be thrown off-course, however, such as a sharp slowdown in the Chinese economy.

The outlook for commodities is also affected by factors affecting supply rather than just demand. In recent years these supply factors have particularly hurt the prices of energy commodities (such as oil and gas), which are largely responsible for the poor performance of commodities so far this year. Techniques such as hydraulic fracturing (or “fracking”) have led to increased energy production, especially in the US. Supply could increase further as technology continues to improve and makes energy production more profitable.

Over time, however, commodity prices have a self-correcting aspect: lower commodity prices themselves help reduce supply by making commodity production less profitable. This process doesn’t occur instantaneously, which is why commodity prices sometimes move up or down dramatically. But it does suggest that as commodity producers adapt to lower demand, prices are unlikely to keep falling for too much longer.