Rethinking Safe Haven Investments

The global credit crisis was marked by a sharp and protracted sell-off across most major financial markets.  During the worst moments of the crisis, investors sought refuge in a mixture of perceived safe haven assets comprising principally cash, U.S. Treasuries and precious metals predominantly gold), according to our research team, the combined Chief Investment Office and Wealth Management Research–Americas (CIO/WMR). As a consequence, Treasury yields fell to generational lows, gold prices surged and the cash balances ballooned. As the most acute stage of the crisis passed, investors started to venture—albeit tepidly—back into a broader mix of risk assets, including stocks and corporate bonds. But the tendency to retreat to a combination of perceived safe haven assets at times of market stress, geopolitical turmoil and “growth scares” persisted for much of the ensuing four years. Investment decisions were based on whether

markets were “risk on” or “risk off.”

 Beyond risk on/risk off

As the crisis recedes, the tendency for markets to move in tandem will continue to break down, in CIO/WMR’s view.  Rather than being driven exclusively by macro events in a uniform manner, the performance prospects across asset classes have become increasingly nuanced and disparate.

Markets are being driven more by differences in growth prospects, earnings outlooks and expectations for monetary and fiscal policies and valuations, less by tail risk events. So instead of equity markets rising or falling in unison as part of a reflexive risk on/risk off dynamic, there is increasingly greater differentiation by region, sector and market capitalization level. In short, the correlations both across and within asset classes—which spiked during the crisis—have continued to normalize, suggesting that greater selectivity is now warranted. This greater differentiation applies to perceived safe haven assets as well.  The tendency for cash, bonds and gold to provide respite at various points over the past few years has left some investors with the impression that these asset classes will continue to insulate portfolios in the same manner going forward. CIO/WMR finds, however, that the principal performance drivers for each of these assets differ greatly, as will their safe haven properties from this point on.  There is therefore no reason to expect that each of these presumed safe haven assets will offer identical or even similar levels of protection from different sets of risks.

 A more differentiated approach

As the various sources of risk have become less acute and less correlated, an investor’s approach toward holding inherently defensive assets must change. CIO/WMR feels a more thoughtful segmented approach will be crucial going forward. Just as greater differentiation will be the key to performance within risk assets, distinctions must also be made among potential safe haven candidates. Here is CIO/WMR’s overview of these assets’ characteristics, the types of environments in which these assets may or may not perform well and thoughts on how investors may want to consider repositioning them within investment portfolios:

 Gold. Perhaps no asset drew as much attention in the aftermath of the crisis as gold—and for good reason.  Gold is often viewed as a hedge against certain extreme outcomes, simultaneously offering protection against:  unexpected inflation acceleration; currency debasement; financial system failures; and geopolitical unrest. With the world forced to confront each of these threats over the past several years, gold has remained well-supported.

 All these factors have contributed to a decline in real interest rates, a key determinant of gold prices. Indeed, since gold provides neither yield nor cash flows, falling real rates support gold by reducing the opportunity cost of holding it. In addition to low interest rates, precious metal prices have been bolstered by unusually high investment demand driven by “fear factors” as markets have periodically dealt with the prospects for a rekindling of the credit crisis, fears of an implosion of the eurozone, escalations of tensions in the Middle East and risks of a technical default of U.S. Treasury debt.

Gold is sometimes utilized as a store of value and a medium of exchange, making it a partial hedge against inflation. As a result, the demand function for gold is more complex than any other commodity, with pricing dominated by one or more drivers. At this stage of the business cycle, however, balance on the gold market requires a major amount of financial demand, which in turn requires sustained low real interest rates. So, while CIO/WMR continues to see upside for gold over a tactical horizon, it also notes, as monetary policy normalizes and yields rise, investor interest in gold could wane over the next three to five years. It should therefore be viewed as a portfolio hedge against adverse outcomes, not a safe haven asset.

Treasuries. The drivers of government bond prices are more straightforward since Treasuries are no more than a collection of fixed cash flows in the future (periodic interest payments and a principal repayment). Discounting these cash flows by the appropriate discount rates and term premium determines the price of Treasury debt. The factors that influence these market rates include economic growth prospects, overall inflation expectations, market liquidity preferences, and monetary and fiscal policy. During periods of weak growth, low inflation and accommodative monetary policy, long-duration Treasury debt tends to perform well.  On the other hand, improving growth prospects, rising price pressures, widening fiscal imbalances and tighter monetary policy will tend to weigh on bond prices. It’s therefore not surprising that bonds performed well during the most recent soft patch in U.S. economic data. Treasuries are an excellent hedge against worsening conditions and, CIO/WMR believes, one of few portfolio diversifiers that can help protect investors from adverse scenarios.

Cash. During the crisis, cash served as a comfortable and convenient place to park funds amid periods of heightened market illiquidity and financial system stress. However, it failed to provide the diversification benefits of Treasury bonds or gold. Cash is unique among safe haven assets in that it demonstrates no correlation to other markets in the near term. So while cash offered temporary respite from the sharp sell-off in risk assets during the crisis, it failed to generate the same level of returns that Treasury bonds and gold offered.  In addition, holding it for too long also inevitably leads to significant erosion in real purchasing power. With monetary policymakers seemingly committed to an extended period of near-zero short rates as a means of supporting the economic recovery, returns on cash are likely to remain below inflation.  It’s been more than four years since the most acute phase of the crisis and cash balances in many portfolios remain at elevated levels. In CIO/WMR’s view, since cash offers neither effective diversification nor protection against an erosion of purchasing power, balances should be reduced to levels required to meet short-term liquidity.

 Let’s talk about it

The above was based on the May 2013 Investment StrategyGuide from the UBS Chief Investment Office and Wealth Management Research–Americas. To obtain a copy of this report and discuss how its research insights might bear on your portfolio, please contact me or a member of our team at 540-855-3344.

 Eddie Link

Meridian Wealth Management

UBS Financial Services Inc.

e-mail: [email protected]

540-855-3349

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