Monetary responders: are these the heroes your portfolio needs right now?

While the rest of the world grapples to understand the long-term implications of the US treasury secretary's bond market interventions, the two assets most attuned to sniffing out the risk of monetary debasement, gold (and Bitcoin), have already voted. 

That's why building and augmenting a diversified portfolio has never been more important, particularly as questions about Bessent's decisions this week reignite enthusiasm for the 'debasement trade'.

We recently wrote in detail about our views of how to build a better defensive sleeve in a diversified portfolio. 

 In short, government bonds may be less likely to provide the defensive ballast in a portfolio because of governments’ large fiscal deficits, and the increased frequency supply-side inflation shocks and so investors need to diversify their diversifiers. 

The new portfolio construction

We recommend improving portfolio resilience by reducing the allocation to government bonds and substituting in a combination of:

• ‘First Responders’ (long volatility) to help with short, sharp equity shocks;
• ‘Second Responders’ (trend following) to help with prolonged downturns;
• And ‘Monetary Responders’ for when the source of the problem is a loss of confidence in the value of money itself.

One way to view gold is as an insurance asset. Something you buy and hope that you don’t need it, but from time to time you’re glad that you have it. The utility of this insurance property drives the monetary premium which determines gold’s value. 

 Here’s how it works:

• Some proportion of investors have a preference to hold a percentage of gold in their portfolio.
• The proportion and desired portfolio percentage vary through time depending on how worried investors are about stuff.
• As gold has a relatively fixed supply (around 1.5%/year) this behaviour drives bull and bear markets in the gold price.
• This averages out over the long run and we show here that the relationship between the market capitalisation of gold and the total value of financial assets is very closely linked. The relationship between the market capitalisation of gold and money supply is a very close one as well.

Finding monetary responders

In that same article, we use this relationship to develop capital market forecasts for gold and Bitcoin and present modelling showing that adding these Monetary Responders to the typical 70-30 portfolio can improve expected returns and reduce expected volatility. This finding holds under more conservative return scenarios than the capital market forecasts we proposed.

Occasionally you will read analysis which shows that changes in the gold price are uncorrelated with inflation. That’s often true but it misses the point. Our research has shown that gold tends to lead inflation, which may be explained by investors spotting the things that are happening today which may lead to inflation one to two years down the track.

The important thing is that this approach to building a better diversifying sleeve and thus a more resilient portfolio does not rely on forecasting the direction of investment markets or specific assets. 

 It’s about letting the traditional growth drivers continue to do the heavy lifting and rethinking the composition of the defensive assets to help defend the portfolio against a broader range of potential crises. A strategic allocation to Monetary Responders is an important component in that process.

We should hope that current fears of financial repression or monetary debasement prove unfounded but it’s probably safer to build portfolios that are less reliant on it not happening.