Hedging against significant risk as markets climb a wall of worry

When things are looking gloomy we can be sure someone will tell us to be positive, to cheer up, to look on the bright side. Well, I've no time for mindless optimism. It makes me think of the old gag about the bloke who as he plummets past the 34th-floor window calls out: "I'm alright so far".

So let's stiffen our spines, put on our reality hat, and look at the world with cold hard eyes. The VIX is at 26. Europe is funding Russia's war to the tune of $40 billion in gas and oil dollars a month. Interest rates are threatening to rise faster than our climate-impacted sea levels. Global supply chains have congealed. And inflation is proving to be stickier than a stick.

All of which is hammering risk and growth assets such as equities. So what do longer-term investors - who can't just sit in cash as inflation eats their savings and who need exposure to some of those risk assets - what do they do?

It's a consideration Stephen Coltman, portfolio manager at abrdn, has given some thought to. He argues that having "protection for both sides, for the extreme positive environments and those extreme negative shocks, makes sense in a balanced portfolio."

For detail on a balanced protective strategy, and for his views on what the fragmentation of financial markets could mean for the Eurozone  - and the impact of commodity and energy prices going up - please click the video below. 

This transcript has been edited for clarity and length

Where are you seeing sources of market volatility?

I would say, in the longer term, I think we've seen a significant regime shift in the markets. Something we've not seen for quite a long time. And they say markets climb a wall of worry. Well, it's true that there is an enormous number of things to worry about at the moment. 

And on the inflation side, all of the tailwinds that equities have had in terms easing monetary policy, every time there was any weakness, the banks would increase their easing. 

You've had governments running enormous fiscal deficits, so tremendous support on the fiscal side. And then you've had generally quite low-quality prices which have been supportive for growth.

What you're seeing going forward is all of those issues reverse. You're seeing central banks now very focused on their inflation mandate. They've underestimated the stickiness of inflation. They feel that they're really in the wrong place and they need to move quickly. 

The Fed, you've seen becoming really surprisingly hawkish. Even with the war breaking out in Europe, that did not change their forecast in terms of what they were going to do with interest rates, which is a really surprising change. You'd normally expect a market shock, they immediately switched to an easing bias, but that's not happening this time around.

You then have the fiscal side, where you just automatically, as governments normalise their fiscal spending post-COVID, you're going to see those deficits shrink. Which again, is difficult for growth.

And then you've got obviously, now concerns around supply of commodities and energy prices going up - significant risk factors and potential headwinds for equities.

But again, if you're a longer-term investor, and you can't just sit in cash when inflation is eating away the purchasing power of your savings, people need exposure to some of those risk assets.

But what we're saying is that you have these very wide range of scenarios with major risks. Having some protection for both sides, for the extreme positive environments and those extreme negative shocks, makes sense in a balanced portfolio. 

We are seeing a lot of institutional investors, as we discussed, questioning some of that bond allocation. And looking to maybe split that between taking more exposure on the equity side, where they have higher return expectations, but combining that also with some explicitly defensive strategies to manage those drawdown risks in the portfolio.

Where are you finding opportunities in Europe at the moment?

We don't take a macro view in terms of trying to pick a specific region to apply protection. 

Our role is to apply that consistent protection for a diversified portfolio of global equities. And we need to have that consistent return profile so that investors can understand how it's going to behave and use it as a reliable tool.

But in terms of identifying where some of the big risks lie, then Europe has to be at the focus, in terms of you have obviously a war with Russia invading Ukraine. You have some vulnerabilities in terms of commodity supply to Europe.

And then perhaps in the medium term, what is more significant is if we are in this period of rising inflation, we've had a long period of calm where the ECB has essentially been supporting backstopping all of the finance needs of the Eurozone member states.

As they decide they need to pull back because of the inflationary pressures, then that's going to put some pressure on some of those spreads between the core and the periphery of the Eurozone. 

And if you start to see that fragmentation again of the Eurozone financial markets, then that's going to be potentially a very difficult situation for the markets to deal with.

What is your outlook for the European economy going forward?

Well, you're seeing the US obviously ahead of Europe and Japan in terms of the inflation cycle. 

The central bank there is already starting to pricing in quite significant increases. It's going to be interesting if you start to see Europe move as well, then those German bonds, having been in negative territory, will start to see a positive yield.

And then the question becomes, Germany is in a very good fiscal position but states that have very much weaker fiscal position, like Italy as an example, if they need to finance themselves at a significantly higher interest rate and they can't get liquidity from the European Central Bank, then they're going to have to potentially embark on some real fiscal tightening. 

The government's going to have to really try and reign in their spending. And in terms of the economy, going back to that austerity is going to be potentially very negative.

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