How to hedge against a downturnContributors Michael Bell, Global Markets Insights Strategy Team
This is close to being the longest economic expansion on record. Nobody knows exactly when it will end, so it’s worth considering what investments could rise in value when equities and other risk assets fall during the next downturn. By including some hedges, investors can create a more balanced portfolio and help reduce overall portfolio losses when the next economic downturn eventually arrives.
Traditionally, investors turn to government bonds to balance the riskier assets in a portfolio. However, government bond yields in the UK are very low by historical standards. Having barely raised interest rates since the financial crisis, the Bank of England (BoE) has very limited room to cut interest rates.
Furthermore, the current political landscape complicates the outlook for UK government bonds (Gilts). In the event of a relatively soft Brexit deal being reached, the BoE would be likely to raise interest rates at a faster pace than is currently priced into Gilts. Failure to agree a deal could potentially require an election to resolve the Brexit impasse. While the outcome of an election would be hard to call, the prospect of a change in government could change the outlook for public spending and in turn put upward pressure on UK borrowing costs.
Investors may therefore want to consider government bonds outside of the UK, particularly in markets where the central bank has more room to cut interest rates during a downturn. Having raised rates by more than the BoE, the US Federal Reserve (Fed) has more room to cut interest rates during the next downturn.
Treasury yields have more room to fall than gilts
EXHIBIT 1: US AND UK 10-YEAR GOVERNMENT BOND YIELDS
BBTP provides investors with access to the performance of dollar-denominated government bonds across the full yield curve by closely tracking the J.P. Morgan Government Bond Index United States.
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