Haven or Horror?
Skerritts View – September 2017
The last time that there was a meaningful correction was in the January of 2016. At the time, we were quite confident that the markets were due a tumble of some proportion and so we tried to defend our portfolios by going overweight absolute return funds. Well, it’s not making the mistakes that cost you….it’s failing to learn from them. One or two of the absolute return funds that we invested in were absolute rubbish in doing what we had hoped from them. Not only did they follow the market down; they failed to catch the bounce when it came. A harsh lesson was learned.
Importantly, though, it was a setback, but not calamitous, as one would hope from a properly diversified strategy. It’s made us think harder about how we prepare for the next correction which is inevitable, and maybe a little overdue. Do we simply sit on our little boat and wait for the storm to bear down on us, crossing our fingers that we’ll still be afloat when it’s passed, or do we take precautions and stay close to land so that we can run for shelter when we need to? Crucially, that shelter, if we’re using it, needs to be on the right side of the island to give us cover and not be on the storm side which sees us dashed against the rocks. A dodgy analogy, perhaps, but you get our drift, hopefully.
So what has got us checking the havens right now? It’s the Axis of Irrationality that is the US-North Korea shouting match.
Markets became very twitchy in early August as tensions were ratcheted up between two of the most volatile world leaders to ever have had nuclear capability. What concerned us particularly was that it was only two days after China and Russia appeared to be helping out by backing a raising of the levels of sanctions against North Korea that the US President delivered his “fire and fury” speech. If he is trying to manipulate the world’s perception that he is mentally unhinged in order to enhance his negotiating leverage then he’s doing a pretty good job, and in this instance North Korea drew back from sending a ballistically wrapped gift to Guam. It’s a dangerous game. With the sending of a missile across Japanese territory, the North Korean hierarchy have raised the stakes once more.
The probability that a nuclear conflict could erupt is, we hope, a slim one, but it is the potential fall-out from the dispute that could cause investors major problems. When Trump came to power there were fears that it could ignite a trade war between the two major powers of the US and China. These fears had appeared to have receded, but a threat on China’s doorstep of US involvement with its allies could easily ramp up the possibility once again. Remember that Asia is the manufacturing hub of the world and it would be cutting the supply chain should trade relations worsen.
Some excellent research from BCA Research has recently looked at safe havens and asked, not only which are the best ones, but when does one use them? They found that their effectiveness was neither universal nor constant. Much depended upon the type of crisis that was being defended, and where it was situated and between whom. What do we mean by this?
Crises can be generally bracketed into three types: financial, geopolitical or business cyclical. Of great importance though is to try to determine whether the event in question is a “red herring” or a “black swan”. A red herring will be a crisis that has little lasting financial impact but which feels serious at the time – for example the Greek referendum or the Russian invasion of Crimea. A black swan is an event that has a low probability of occurring but has a pronounced effect on markets if it does – for example Lehman going bust or the Euro Area Crisis of 2011. Of course, it only becomes clear whether it was a herring or swan-related incident with hindsight.
The Korean peninsula is beginning to take on more black swan characteristics than red herring. True, the fear of nuclear conflict remains (we hope) a red herring, but the crisis itself is of a nature now whereby it is not going away and has a few dangerous phases to go through yet, with each phase increasing the chance of policy error on either side. If push came to shove, China would almost certainly keep on the side of North Korea and the chances of some kind of trade war increases with each battery of rhetoric fired between the two sides.
So what are the traditional havens? Usually, in times of crisis, investors can rely on Developed Economy Government bonds (Gilts, US Treasuries, JGBs and Bunds), currencies such as the US Dollar, Japanese Yen and Swiss Franc, and gold. Interestingly, research has shown that these havens’ effectiveness decreases if the seat of the crisis is situated in the region of denomination. Also, Baur and Glover (2012) have put forward the thesis that gold has become less of a safe haven since it became a vehicle for speculation and hedging – that it can not be both an investment and safe haven asset. Since the advent of the ETF, gold has become far more liquid than ever before as it can be held now in daily-traded certificated form rather than as old fashioned bullion needing storage and insurance costs.
This finding may have something to do with the most recent crises since the explosion of ETFs on to the markets being financial, which tend to see Government bonds come to the top of the haven charts in any case. Business cycle and geopolitical crises have seen gold act as haven of choice in general terms, and since 2008 it is fair to say that we have not witnessed a serious recession nor seen a genuinely serious geopolitical world event.
If this is now beginning to change, with geopolitical events taking centre stage in the US and Asia, and the consequences of which could lead to a global slowdown and recession, is gold due to reclaim its top spot? Bear in mind too that this particular spat is being played out in a theatre in which Japan has a front seat, and involves a United States embroiled in increasing domestic and overseas blurring of policy. Does this lead us to view the traditional havens of the US Dollar and Japanese Yen as first choice? Not in this case, although if there is a slowdown which affects China and the US it is very hard to see how the commodity currencies can outperform, so a US v commodity currency hedge could be effective.
It’s early days, but since the latest round of missile launches began on July 4th this year, gold has risen around 6%. This is some three times bigger than global and government bonds, while equity markets have hit the retreat button.
The chances are that this crisis will not develop into something of eye-watering significance, but if you have the chance to build some insurance into your portfolio we fail to see why one would not do so. In our portfolios we have introduced gold and have maintained our bullish USD v commodity currency position, as well as raising cash. We sincerely hope that this is a relatively short term move and we will remain committed to accessing our favoured sectors of robotics, cyber, healthcare and ageing population in the meantime. We think we may be able to buy more of these sectors more cheaply in the coming weeks with our safe haven proceeds. Having been out of gold for a few years, we think that it may be time for it to shine once more.
NB All assets carry an element of risk
BCA Research September 2017
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