Preparing portfolios for the unexpected

Need to know The current market consensus for a soft landing is flanked with well-articulated downside risks to growth or concern about inflation remaining high and sticky. Markets are hedged for a consensus scenario and volatility prices suggest a Goldilocks environment What if an extreme scenario of stagflation were also taken into account? We believe investors should prepare portfolios for the full gamut of possible outcomes in a dynamic process that adapts as circumstances change

 

A reshuffle in three scenarios

Asset valuations are undergoing a considerable reshuffle in 2022, from bonds to equities to commodities. This vast reshuffling of the cards reflects a rapid rise in interest rates and especially in long-term real rates. The rise in real rates is unprecedented since the establishment of inflation-linked bond markets in the late 1990s, and triggering deep concern as US 10-year real yields approach 1.5%.

This is a logical development: as central banks tighten funding conditions, they aim to slow the economy enough to purge it of inflation. The economic slowdown is already occurring and challenging the investment community in its beliefs. Expansion is giving way to contraction, and the consensus (scenario 1) at this stage is that growth over the next few months should become slightly negative while inflation quickly returns to the target of most central banks, the sacrosanct 2% level. Often referred to as "soft-ish-landing", this scenario reflects a normalisation from an overheated period, generating a little bit of pain but not too much.

There are risks associated with this central and reasonably optimistic scenario. Some see the risk that the recession will be deeper than expected, while nevertheless purging the economy of inflation (scenario 2). Others foresee a more limited slowdown accompanied by a rapid decline in inflation (scenario 3). Scenario 2 is likely to be accompanied by a rise in bonds and a fall in equities. Scenario 3 could support equity markets after a complicated year. Figure 1 shows the distribution of economists' expectations - the most negative anticipation is clearly a moderate recession, but without inflation.

 

Figure 1. Distribution of real GDP growth forecasts in the US

Source : Bloomberg, LOIM. For illustrative purposes only.

 

Adding an extreme scenario

To these three risk scenarios, we raise a fourth outlier risk scenario: that of a deep recession accompanied by persistent inflation. This scenario is clearly underestimated by economists, and would weigh heavily on markets across asset classes. The presence of inflation would pressure fixed income markets, pushing investors to seek inflation hedges instead; the deep recession would lead to a revision of earnings expectations, which remain high in our opinion at this stage; finally, the continued appreciation of the dollar against a backdrop of high real rates would limit the prospects of gains in commodities, particularly precious metals. In this unexpected scenario, investors would only be protected by so-called true alternative investments (with zero explicit or implicit beta) and/or cash.

Is the market ready for such a risk? It would be wrong to assume that positioning is bullish equities or that investors have not loaded their portfolios with hedging instruments. Hedging flows are unprecedented. However, as discussed previously, these hedges are calibrated for reasonable moves, basically congruent with the consensus scenario 1. But they would perform poorly against a more radical downside scenario such as a rise in volatility and/or price shift in the equity markets of 20% or more.

 

Volatility disconnect with risk

Against this rise in volatility, investors appear woefully unprepared as indicated by the joint level of the VIX and the VIX volatility indices - the VVIX. Figure 2 illustrates this point: the VVIX is around its 2017 average - its "Goldilocks" average - an environment that has clearly been abandoned. It is through the rise in volatility that deep equity market declines can occur, and that is where the risk lies for us today. The recent equity market falls reflect only a marginal increase in the pricing of this risk, in our view.

 

Figure 2. Recent evolution of the VVIX

Source : Bloomberg, LOIM. For illustrative purposes only. VVIX refers to the implied volatility of the VIX volatility index itself (and as such represents anticipated volatility of volatility).

 

An underestimated risk

Economists and investors alike underestimate the same risk: a deep recession with persistent inflation (stagflation), a scenario that would theoretically lead to a deep and rapid decline in risk-on markets. This type of movement usually occurs in three stages.

The first stage is a relatively slow and orderly decline in markets similar to what we are witnessing today.

The second stage corresponds to an increase in the speed of the drawdown, associated with this higher realised volatility, i.e. a sequence of larger than usual negative and positive returns, as uncertainty grows.

Finally, the third stage is an increase in the volatility of volatility, with prices and volatility experiencing outsized variations both ways on the back of a heavy news flow and knee-jerk positioning. This is the true tail, and what occurred in 2008 and 2020.

We are clearly not there. Nonetheless, it is essential to keep in mind these different stages, their sequence, and the point we have reached now – between stage 1 and stage 2.

 

Preparing portfolios

Whether this tail event scenario 4 is becoming more or less likely is beside the point: stagflation is and remains a non-zero probability scenario that needs to be anticipated. Investors can make their portfolios more robust and balanced only by stress testing against the full gamut of scenarios, not just consensus situations. Putting weight on all possible outcomes, including extreme ones, changes the allocation relative to assigning extreme outcomes a zero probability. 

We are not suggesting that investors should divest from bonds and equities. Our analysis instead leads us to believe that a balanced and robust portfolio incorporates a higher level of cash and alternatives. How much more? This depends on the likelihood assigned to the different scenarios and forms part of a dynamic process as the probability assigned to each scenario evolves.

As circumstances change, so should your portfolio.

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