ROI-Iran war exposes 60-40 portfolio frailty: McGeever

The opinions expressed here are those of the author, a columnist for Reuters

By Jamie McGeever

ORLANDO, Florida, March 3 (Reuters) - For investors, the conflagration in the Middle East and flaring geopolitical tensions worldwide raise an uncomfortable question: how can you hedge these risks if the traditional equity-bond portfolio no longer works?

The answer isn't immediately obvious, but the volatility that has rocked world markets since the U.S.-Israeli attacks on Iran over the weekend suggests the pressure on investors to find one is only going to intensify.

Implied volatility in U.S. Treasuries on Monday rose the most since April, as bonds sank across the curve. Implied U.S. equity market volatility on Tuesday had its biggest rise since October, as stocks around the world tumbled.

Historically, the first port of call for investors scrambling to hedge against geopolitical, economic, or financial market risk has – along with gold – been Treasuries, long viewed as the safest and most liquid financial asset on the planet.

Bonds were traditionally expected to appreciate during risk-off periods, muting the volatility in equities. This led to the widespread adoption of the traditional portfolio allocation: 60% to stocks, and 40% to bonds.

But since the COVID-19 pandemic, America's mounting fiscal deficit and public debt, along with elevated inflation, have gradually but steadily eroded Treasuries' status as the natural hedge against equity risk.

As a result, the 60/40 portfolio's in-built safety mechanisms have eroded.

This was among the main findings in an International Monetary Fund blog last month - a timely report, as it turns out - in which the authors note that bonds and stocks now often move in tandem, especially during sharp market sell-offs.

Investors of all stripes, even conservative institutions like pension funds and insurers, are thus exposed to greater volatility and deeper losses. That, of course, also increases financial stability risks for policymakers.

"If diversification fails, volatility can cascade into broader financial instability. Investors and policymakers must rethink risk management for a new era where traditional hedges fail," they said.

DIVERSIFICATION OVER CORRELATION

The IMF note argues that investors must explore alternative hedging and diversification strategies, but what exactly should these be?

The blog post highlighted private assets as a potential portfolio buffer against market panic given that they often have lower levels of volatility than publicly traded assets. But recent events in private credit show that the opaque private markets universe comes with its own risks.

The post also suggested that commodities should be considered. But those arguing that 'hard assets' offer the best hedge against political risk will have been disappointed by the performance of gold and precious metals this week. Bullion XAU=, the most established "safe-haven" asset and traditional hedge against inflation, rose only 1% on Monday and is down 2% on Tuesday.

Meanwhile, platinum XPT= and silver XAG= have tumbled 10% since trading opened on Monday. This suggests speculative, short-term flows are driving precious metals prices as much as traditional economic "fundamentals."

Many other commodities – with the notable exception of oil and gas – are also under selling pressure, including corn, wheat and especially copper. Of course, these are short-term moves, but if they don't reverse, one wonders where the hedging and diversification outlets for investors are.

NOT DEAD YET

It's worth noting, however, that before the Iran strikes, Treasuries appeared to be regaining their diversification mojo. The daily correlation between stocks and bonds turned negative during the first two months of the year and was approaching average levels recorded in the pre-pandemic decade, according to Truist Advisory Services.

Was that just a short-term anomaly? Potentially not, argues Keith Lerner, chief investment officer at Truist.

While the current jump in oil prices may make Treasuries less attractive, given the risk of higher inflation and tighter monetary policy in response, a sustained period of high energy prices will soon become a recession risk, Lerner argues. If so, bonds look attractive again.

"Our view that high-quality bonds should generally still act as good portfolio diversifier has not changed," Lerner said.

Ultimately though, when political machinations are driving market prices and sentiment rather than economic or policy fundamentals, risk-management playbooks and diversification models often go out of the window. Investors, whose expertise is understanding how economies and markets work, are not usually great at predicting how long wars will last or how they will end.

"Whether this conflict is long or short, at least let it be a lesson for you to increase your diversification to a wider range of outcomes," said Bob Elliott, CEO and CIO at Unlimited.

That is the challenge investors face now – and it's not an easy one.

(The opinions expressed here are those of Jamie McGeever, a columnist for Reuters)

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(By Jamie McGeever; Editing by Marguerita Choy)

((jamie.mcgeever@thomsonreuters.com; Reuters Messaging: jamie.mcgeever.reuters.com@reuters.net/))