While many investors have flocked to haven assets in the face of volatility and the prospect of recession, there are others who are not changing course. Walking placidly amidst the haste and noise, they stay focused on their long-term objectives, typically underpinned by a balanced 60-40 stock-bond exposure.
But according to Randy Swan, founder and lead portfolio manager at US-based Swan Global Investments, investors should re-examine their expectations of safety from bonds. “[T]he inevitability of the next market downturn is not the biggest problem that most clients face,” he wrote in a piece for WealthManagement.com. “The greatest challenge at hand is that the average portfolio—one made up of 60% stocks and 40% bonds—is not built to weather new market realities.”
He explained that despite their remarkably performance through thick and thin over the past few decades, that may not provide as much downside protection going forward as the intensifying tight-spread, low-yield environment seen this month appears set to stay.
“It is a major red flag that the yields on the 10-year U.S. Treasury note and the two-year U.S. Treasury note have inverted,” he said, adding the fact that many large institutions hold bearish near- and immediate-term outlooks. That a 2% yield is considered palatable, along with the unabated downward momentum in yields, are other indicators of desperate times.
“The long-run limitations of fixed income are also continuing to manifest in the corporate bond market,” Swan said, citing relatively paltry coupons and weak protections that come with investment-grade and high-yield debt. In today’s era of “covenant lite,” he said, the vast majority of investors face inadequate compensation for risk, raising the prospects of portfolio pain through increased distressed and new defaults from steep principal haircuts when recession hits.
He argued that governmental action, including interest rate cuts, is not likely to stem volatility or offset waning corporate investments. Given record national debt levels and annual deficit levels, the potential for artificial stimulus through increased spending or tax cuts will be constrained. Central bankers, for their part, have their hands tied from an already bloated balance sheet and dismally low interest rates.
“Any advisor looking to help clients preserve and grow capital at a meaningful long-term rate needs to leave behind the strict balanced portfolio playbook,” Swan stressed. The 40% of a portfolio devoted to fixed-income securities, he maintained, must be rebuilt to accommodate new long-term investment solutions. Accredited investors may consider alternative assets, and others may seek safety in cash or precious metals; but for most clients worrying about a comfortable retirement or how to reach individual wealth goals, those aren’t suitable paths.
To balance capital preservation goals while capturing stock-market appreciation over a full cycle, Swan suggested getting exposure to a hedged equity strategy.
“Many investors do not realize that they can retain considerable equity exposure during a bear market with a strategy that seeks to hedge downside risk and generate opportunistic income through the use of options,” he said.
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