Every investor worth their salt knows that diversification is the key to giving a portfolio protection against the inevitable ups and downs of markets. Remember the story about eggs and baskets! However, no one worries about diversification when markets are going up. Only when they take a turn for the worse does the topic suddenly come back into vogue.

The third quarter of 2021 delivered a notably weaker performance than throughout the market’s recovery from the depths of the pandemic and we note diversification is once again at the front of investors’ minds. In addition, investors are warily eyeing the relationship between equities and bonds, which broke down in September, inflicting some large losses.

With the longstanding rules of diversification changing, investors are understandably nervous. Most asset classes have benefited for years from easy liquidity conditions. With an inevitable tightening cycle on the horizon, we could see most risk assets suffer. So how are our investment teams managing to diversify against a murky economic backdrop marked by rising inflation, paltry growth and the very real risk that central banks get it wrong? I would like to look at three areas in particular.

Cash

Bull markets typically start from a point of very low valuations when investor optimism has been hit by war, recession, or a pandemic and interest rates are low or falling. Today, none of these factors apply.

Valuations are high, as are profit margins, and interest rates are on the turn. In these circumstances, fund managers are increasingly pointing to the merits of a higher short-term cash allocation as ‘the least bad option’. There is no disputing cash has been a terrible long-run investment (except in Japan), but the situation over shorter time horizons is different.

One of the most common arguments for being bullish on almost any asset is that it will be more appealing than holding the alternative, i.e., cash. However, as Morgan Stanley pointed out in a recent research note, the ‘cash is trash’ mindset is catchy and persuasive but can also be misleading. The argument mixes the long term (where cash usually loses) with the short term (where its record is far better). It frames cash as the alternative when, in reality, the trade-off is rarely that binary. With inflation in the UK likely to be more sticky than transitory, courtesy of Brexit, Covid-19, higher energy prices and a lack of clarity on the state of the UK labour market, fund managers are turning away from sterling bonds and instead choosing to hold that money in cash.

Cash is a very good diversifier to have in the short term. However, you lose money in real terms if inflation is high, but over the next few months having a significant cash weighting could be a very good idea.

Most assets are better than cash most of the time, but cash can outperform in the short run. A strong argument to hold (some) cash is that it will return more with less risk. Of course, this is not an all or nothing argument. After all, fund managers are given money to invest, not to park in a bank! Some allocation to cash can act as a small flexible buffer, typically our investment teams think around 5% to 10% as a ‘war chest’ to buy into market dips is a good call.

Gold

With confusion on the outlook for inflation likely to spill into bond and equity markets, therefore stoking volatility, many may turn to gold as the port in a storm. Gold is touted as the ultimate diversifier, in other words, the place to be when inflation goes up or the world goes to pot! However, anyone who has held gold will be woefully disappointed with the ‘protection’ the yellow metal has delivered. The truth, though, is gold has done exactly what it is supposed to do. The gold price falls when interest rates are likely to rise and there has always been a very strong inverse relationship between gold and real interest rates. This means gold is not an inflation hedge, despite everyone touting it as such. Put differently, gold is not a good diversifier when interest rates are rising.

The big question is whether interest rates will rise. They shouldn’t, but that does not mean they will not. The Bank of England may start raising rates in response to inflationary trends, when factors such as rising energy prices are in fact disinflationary (they reduce a consumer’s discretionary spending). Raise rates too soon and there is the danger of creating a recession at a time when the economic fallout of Covid has not dissipated and deeply indebted governments are spending money like there is no tomorrow.

There is a very real risk that central banks miscalculate on rates, not least because there are no economic parallels in history on which to base their assumptions. The bottom line is, while gold is probably not the answer, government bonds most definitely are not!

Corn, Wheat, Pork Belly & Oil (aka Commodities)

It is not just markets that are likely to be choppy. You do not need to be a meteorologist to see more volatility in the seasons too, which will have an impact on agriculture. Introducing ‘soft commodities’ such as wheat and corn as diversifiers into a portfolio may be challenging given the complexity of commodity futures prices, but investment managers could introduce these via exchange traded funds (ETFs). We will be discussing this area with our investment over the coming months.

If the past few weeks have taught us anything, it is how reliant on oil the world remains. Whether it is Russian gas pipes, Middle Eastern unrest, or Brexit/Covid-induced labour market shortages, political instability means oil remains a constant risk and one to diversify for.

Rising energy prices are a massive tax on growth, which means every well-diversified portfolio should have some exposure to oil and gas. Of course, the time to buy oil was 20 months ago, when the price was depressed but that is the point about diversifiers. You need things in your portfolio that are going down when everything else is going up. That’s what diversification is, and it always comes at cost — much like insurance. You might not need it at the time, but when you eventually do, you are always happy you paid for it.

For further information about these topics or any other issues, please speak to your Prosperis adviser on 01423 223640 or email advice@prosperis.co.uk.

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