Authored by Simon White, Bloomberg macro strategist,
Know your tails. In a year facing an unusually wide set of outcomes, knowing what the tail risks are and how to hedge them is of paramount importance.
The top three tail risks I see facing the global economy - and three havens offering a refuge - are:
Stubborn or resurgent inflation —> commodities and other real assets
US recession —> shorter-dated Treasuries or bills (or even cash)
Global funding crisis —> US dollar
A non-negligible risk facing markets this year and beyond is inflation that fails to fall back to pre-Covid levels and remains stickier and more entrenched. In this case, a greater exposure to commodities and other real assets is essential.
Commodities were the only main asset class to deliver a positive real return in the 1970s. Stocks, corporate bonds and US Treasuries all posted negative real returns in that decade. Moreover, commodities, despite their post-Covid rise, continue to be generationally cheap versus stocks and bonds.
Simply put, the investment community is still woefully underweight commodities, an asset that stands to be one of the few beneficiaries of persistent inflation. Using US ETFs as a proxy, commodities are only 2% of the total invested in stocks, bonds and commodities. Even a small redirection of flows from financial assets to commodities would lead to outsized gains in the latter.
Commodities are also a hedge against rising geopolitical risk, as countries seek to fortify their accessibility to raw materials essential for energy, infrastructure and renewable technologies.
How best to find safety from a US recession, the most likely of the three risks highlighted? Several reliable leading indicators are consistent with a recession beginning as early as the summer. Given the weight of data in favor of a slump, it would be remiss not posit that one is likely.
Treasuries are the haven of choice in a recession. Aside from their liquidity and the support they get from rate cuts, they benefit from raw fear: if you know in a panic people reach for US Treasury debt, then it’s rational to panic first.
Bonds have generally gone up for most of the past 40 years, so any historical analysis will have that bias. Still, it is clear from the chart below that Treasuries on average see an acceleration in their rally after the recession begins.
The caveat this time around is we are in an inflationary world, and bonds may not rally as much in an inflationary recession.
A way to mitigate this risk would be buying shorter-dated USTs or bills, avoiding some of the larger real capital losses that would come with longer-maturity debt.
Moreover, despite the recent rally, USTs are still deeply oversold and speculators remain very net short, meaning any rally has the potential to be turbocharged in a flight to safety.
The third major tail risk facing markets this year is a funding crisis, for which the dollar is a place of refuge. It remains the dominant currency in the international monetary system, despite initiatives to reduce the dollarization of the global economy, such as closer trade cooperation between China and Russia, and a mooted expansion of the BRICs. It eclipses the euro, yen, sterling and the yuan in FX reserves, debt outstanding and trade settlement.
Source: Atlantic Council
The Fed thus remains not only the domestic lender of last resort, but the international lender of last resort. Yet the US central bank is contracting its balance sheet, with the pace set to rise this year. The stickiness of the overnight reverse repo facility will ultimately ensure bank reserves bear the brunt of QT, heightening risks that dollar funding becomes scarce and expensive.
Disruptions to dollar funding often become self-fueling, due to the structural dollar short inherent in the global monetary system. In the chart below, we can see that rises in the dollar lead to falls in global crossborder lending in USD, as borrowers scramble to source dollars that are rising in cost, leading to default and deleveraging.
The dollar is likely to remain in a downtrend as long as the real yield curve keeps flattening, but it continues to be one of the best hedges if dollar-funding pressures arise this year, especially against EM currencies of countries with large external-debt positions and sizable current-account deficits, such as Turkey, Chile and Hungary.
Markets also face mounting exogenous risks this year, for instance a Chinese invasion of Taiwan. Although not discussed here, such risks would likely precipitate at least one of the outcomes already highlighted.
In any crisis, it’s not about seeking what assets return the most, but finding what loses the least.
The options highlighted can’t be guaranteed to offer a positive return, especially in real terms, but they stand in a good position to outperform other assets in the scenarios explored.
A haven is defined as a “safe or peaceful place”. Unfortunately, 2023 is unlikely to offer any truly tranquil escapes, but real assets, USTs and the dollar promise to act as sturdy life rafts when a storm hits.