- Economic laws can’t be muted forever, and in the end always get their due, therefore it is good to look at other options to de-risk your portfolio.
- Gold is too volatile to be considered a safe haven.
- Diversification should be the best option to avoid losing everything in a market downturn.
Economics is pretty straightforward. The first thing they teach you in ECON 101 is that the economy works in credit cycles. In a positive environment with low risks and low base interest rates, people borrow and spend. They buy a new car, go on trips, refurbish the kitchen and so on, which leads to economic expansion.
But there is only so much you can borrow, with two new cars in the garage of your new house you start feeling a bit tight and as all your main spending needs are satisfied, you start deleveraging. This leads to an inevitable recession.
Even if a recession might sound crazy at this moment in time, don’t forget that we have had 11 of them since 1945 with the average expansion cycle lasting 58.4 months and the average contraction 11.1 months. The current expansion is already 84 months old which statistically should have led to a recession, but the FED hasn’t allowed for a normal, healthy economic cycle to evolve and is trying to manage economic cycles. The more the economic expansion period is artificially stretched, the stronger the negative economic impact of a future recession will be. A good example to look to is the 2007-2009 Great Recession, which was the longest since the Great Depression.
The Japanese example perfectly demonstrates how monetary easing has its limits. Monday’s data showed that the Japanese economy expanded at an annualized rate of 0.2% in Q2 2016 despite government stimulus.
Figure 1: Annualized quarterly change in Japan’s GDP. Source: Wall Street Journal.
As long term investors, we have to follow the main rule of investing which is not to lose money. Therefore, it is of essential importance to always be looking at risks, which I know isn’t as sexy as buying stocks, but it is what gives long-lasting and outperforming returns.
Among the many risks for investors, today we are going to focus on how safe traditional investing safe havens really are.
Investing Safe Havens
The definition of an investing safe haven states that the investment is expected to retain or even increase its value in market turmoil. The typical safe havens most investors consider are gold, U.S. treasuries—especially TIPS or Treasury Inflation-Protected Securities,—the Swiss franc, and defensive stocks. We shall discuss each of these below.
Gold is considered the ultimate safe haven asset, but due to its incredible volatility, I have a feeling that it’s retail investors who get burned by it, making gold a used-to-be the safe haven.
In wartimes, gold is the only worthy currency due to rampant money printing, however, we are hopefully not even close to a war, but are printing money like we are in a wartime. Even though gold is the ultimate hedge against runaway inflation, we may want to rethink it as a safe haven due to its volatility.
In the 1973-1975 recession, gold surged from below $100 per ounce to above $200 but quickly retreated to its previous level as soon as things got better. In 1980, due to geopolitical instability, gold surged to above $800 and again returned to the $350 levels in 1982. Gold notched up a bit in the 1987 bear market and in the 1991 recession, but did not move in the 2001 recession. In 2002, gold started its majestic bull run from prices around $300 to the highs reached in 2011 of above $1,800, only to retreat to $1,100 this winter. It has again surged to current prices of $1,350/oz.
Figure 2: Gold prices since 1973. Source: Gold Price.
I wouldn’t consider an asset that fell 35% in the 2008 bear market to be a safe haven. Especially given gold’s volatility in the last 10 years, investors should know that gold at this point looks more like a speculation than safe haven investing.
That does not mean we don’t believe you should have some allocation to gold as a protection against an all out fiat currency collapse, just know it will be volatile.
U.S. treasuries carry two risks; one is the default of the U.S. government which is highly unlikely, while the other is inflation which is not so unlikely given the continuous monetary easing. Therefore, in order to really look for a safe haven, TIPS (Treasury Inflation-Protected Securities) should be examined.
If inflation hits 2% or more, 30-year treasury yields would give a negative real return. On the other hand, TIPS have a much lower yield, with the current spread at 162 basis points which is amongst the lowest spreads in the last five years but would keep giving you a positive real return in inflationary circumstances. The current difference of 1.62% is a lot, but protection always comes at a cost.
Figure 3: 30 year treasuries vs. 30 year TIPS – yields. Source: FRED.
The difference in yields demonstrated in the figure above is pretty high which suggests thinking about diversification in the safe haven bond portfolio. As the main rule of investing is not to lose money, TIPS should be considered.
The Swiss Franc
The Swiss franc (CHF) is similar to gold, when things get rough people flock to it, but you have to sell quickly when things get better. In August 2011 the CHF surged due to contagion fears related to the European debt crisis, but it quickly returned to previous values.
Figure 4: USD per 1 CHF. Source: XE.
The CHF is not a long term safe option as it is very volatile and does not provide long term protection.
Defensive stocks usually perform well at the beginning of a bear market but are dragged downwards in later stages as investment funds get tight on liquidity. Defensive stocks can be found in the utilities sector and consumer staples. In the current environment, if you have two stocks with similar valuations and yields you might want to choose the more defensive one as it will limit your losses should a bear market arrive.
Talking about risk is always thankless, you become the grumpy fellow at the party while everyone else is having fun. But investing shouldn’t be about fun, it should be about creating sustainable long-term positive returns.
In this article we have discussed how some safe havens are not that safe due to their volatility and speculation around them, like gold and the Swiss franc. Being protected always comes at a cost which is relatively high when comparing treasuries and TIPS, but it is necessary as global monetary easing and stimulus continues.
The main conclusion is that you have to assess your risks for the returns you are getting. The S&P 500 is up only 4.9% per year in the last 24 months, so consider if those meagre returns are worth the risk of losing more than 20% if a bear market comes along.
The best protection should be diversification that includes TIPS, gold, defensive and growth stocks, domestic and emerging markets. If you continually rearrange the weights in order to minimize risks, you can for certain outperform the market with less risk.