Three Levels of Market Risk and Hedges

Updated: Jan 30

October 14, 2019

Three primary risks to your portfolio and suggested hedges

It is incredibly hard these days to make any investments without fretting over the many dangers that seem to be lurking at every level. Trade wars, huge debt loads, negative interest rates, massive money printing, deficits, unfunded pensions, the list seems to go on and on. Of course, investing always requires taking some risk, more for potentially larger returns. Nevertheless, the current environment appears to be at one of those periodic crossroads that results in large fundamental changes (i.e. ending the gold standard, Bretton Woods). Having started my investment career the year before the 1987 crash, I have imprinted on my brain to always be extra aware of “tail risks” - those infrequent negative outcomes that really jolt your way of doing things. Therefore, a core piece of my investment approach is to look for inexpensive and simple ways to reduce those “tail risks” from wreaking havoc to my client’s and my own portfolio’s bottom line (and our emotional state).

1. Recession Risk

I view today’s "tail risk" dangers to investing in three progressive levels. The first risk is just a normal recession. The economic data appears to be pointing towards a high likelihood of a recession coming soon if it has not started already. The coincident confirmation that will change the general perception (meaning the price level of the stock market) from the current state of optimistic to negative will likely be a rise in US unemployment. That being said, a recession is not the end of the world. Since 1945 there have been 11 business cycles and another will come someday. Many even say this would be a good thing because it would clear out the unproductive, over-indebted companies to set the stage for the next period of growth. The hedge for a recession is well established - hold a significant allocation of U.S. government bonds and notes in a portfolio. The short-term maturities in the 2- and 5-year range are usually most influenced by expectations for interest rates compared with the longer maturities which have to factor in inflation and other confidence considerations. All other things being equal, because the potential price change for shorter-term maturities is normally less than longer maturities, some thought needs to go into selecting which maturity(s) and how much to use as a hedge for a specific portfolio. Whenever it is clear a recession is underway, the Fed has a history of aggressively lowering interest rates in response which in turn is normally very bullish for bills and notes (shorter maturities) and many times for bonds too (longer maturities).

2. Monetary Inflation

The second level of risk is monetary inflation. There are two types of inflation, a “good” type that comes from everyone making more money and then driving the price of goods up when they spend it. The “bad” type is more of an insidious money game. The government creates way too much money than the economy needs and prices have to adjust upward to compensate. For the last ten-plus years, the Federal Reserve has increased the amount and lowered the cost of money in ways that have driven up the value of assets like stocks and real estate. If you were already rich in stocks and real estate, this has been great. Most were not. The time has come now when the average worker (and the indebted young people) are demanding the next round of easy money schemes be directed specifically for their benefit. This may come in the form of infrastructure projects, forgiveness of college loans, basic income, funding of indebted state pensions programs, and so on. Republicans and Democrats alike are in the mood to spend. The money will come from more debt issued by the government (Congress). There will probably not be enough buyers of the new debt, so another branch of the government (the Fed) will create money and buy it. (Or more insidious, skipping the bond part, the government just prints money and directly spends it). This will most likely, at some point sooner or later, create inflation - maybe a lot. For a wonky analysis of this concept (otherwise known as MMT), I suggest this article from Carnegie Endowment for Peace by Micheal Pettis. To be fair, his analysis does point out scenarios that might not result in immediate inflation which are credible, but they also require the government to do the right thing when they borrow/print and spend (hmmm..). Nevertheless, our goal here is to hedge a set of possible bad scenarios, not perfectly predict the future. The traditional hedge for inflation is gold. A portion of a portfolio can be committed to gold in some form. For those comfortable with options, adding some extra protection with cheap call options adds some extra insurance (more on this in a previous blog post here)

Dollar Demise

Now, if that all that not enough to worry about, there is one more on the list. The remaining (probably least likely of the three), is a loss of the dominance of the US Dollar in world trade and finance. Since the mid-point of the last century, the USD has been the primary currency used by the entire world. This has enabled America to borrow cheaply at very low interest rates and has kept the value of the Dollar relatively high. There has recently already been a slow building trend around the world to change this (here is a good example). It would probably take another world financial crisis for the Dollar to be supplanted, but as we have been discussing, there are plenty of catalysts for another crisis these days. If the Dollar was to be replaced rather quickly, the result would very likely be much less demand for U.S. government bonds (therefore higher interest rates) and a much lower relative buying power of the Dollar. This would greatly hamper the US government's ability to borrow (or print) money and spend. The US and world economies would contract. Stocks and other asset prices would likely decline. The general consensus has been this changing of the guard in world currency dominance will be a gradual affair (that would probably not require hedging). But recent events have increased the possibility of a faster switchover which means the risks to a portfolio, especially a Dollar based one, should not be left to chance. Gold could also be the best hedge for this risk but diversification in non-US Dollar assets could also help.

So, to summarize, I see three major risks whose increased probability in today's world makes a strong case for specific portfolio hedges. These are the three risks and possible hedges:

  1. Recession. The traditional hedge is a large allocation to treasury bonds, the shorter maturities should be less sensitive to changes in inflation expectations.

  2. Monetary Inflation. Gold is considered by many to be the original currency and should be expected to price higher in a deflating currency.

  3. Dollar Demise. This one is a bit harder, but the uncertainty of a future without a strong Dollar would probably be very bullish for gold. Diversification in the underlying currency of your investments would potentially reduce the exposure to a weaker Dollar.


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