Building a resilient portfolio amid war, rising rates and inflation

With headlines surrounding the ongoing war in Ukraine, increasing prices at the gas pump and grocery store, and the potential that another uptick in Covid cases will cause renewed supply chain issues, volatility has increased across markets in recent months. These macroeconomic headwinds, coupled with a shift in global central bank policy to be far less accommodative, have many questioning whether their portfolios are positioned to weather the potential for unstable and uncertain times.

In periods of stress, even the savviest investors may let their behavioral biases get the best of them by selling stocks and other growth assets at an inopportune time.

For advisers, it’s no longer simply about creating diversified portfolios, it’s about creating stability and giving clients the confidence to remain invested even when their instincts may be telling them to sell. With negative news dominating the headlines, the need for ballast becomes top of mind for advisers and their clients. Constructing portfolios to reduce drawdowns can help clients realize that investment success often has more to do with time in the market, rather than timing the market, as the old adage goes.

Recently, investors have faced a double whammy, with both stocks and bonds delivering negative returns year to date in 2022. A standard 60/40 stock/bond portfolio return was down 5.1% in the first quarter of 2022, according to Bloomberg data. In fact, U.S. bonds experienced their worst quarter since 1987. What’s more, the greater the percentage of fixed income in a portfolio, the worse it performed, as evidenced by a 20/80 stock/bond portfolio falling 5.7%. This particularly affected those closest to retirement and those with more modest risk tolerances.

2008 EXPERIENCE

In a downturn of any magnitude, many clients immediately recall their 2008 experience, which was challenging for most. However, the 2008 playbook may not apply today.  In the first quarter of 2008, bonds were actually up, helping to protect from the sharp sell-off in stocks. In fact, bonds were positive for the full year in 2008, and while past performance is not indicative of future results, stocks famously bottomed in early March 2009 and ended the year up 26.5%, highlighting the futility of attempting to time the market.

This begs the question, how can advisers construct more resilient portfolios for clients in this environment?

Because longer-dated bonds may no longer act as strongly from a hedging perspective, advisers may want to consider looking to short-duration fixed income or floating-rate notes and loans, as these strategies tend to offer low correlations to stocks and are more likely to see increased income potential as rates rise. They also have the benefit of lower risk from interest-rate increases compared to bonds with longer maturities.

Stock allocations may benefit from introducing strategies with greater downside protection. While many investors seek out stocks in lower volatility sectors, such as utilities and consumer staples, these holdings tend to come with higher sensitivity to interest rates, so they may not perform well if rates are rising. Another option may be combining lower volatility with higher quality and value exposures. Additionally, advisers may also want to look toward dividend growers, which tend to be higher quality and offer attractive yields.

POSITIVE EXPOSURE

Finally, advisers may want to consider introducing alternative investments into client portfolios, especially those with positive exposure to inflation-like real assets. One real asset that has consistently provided ballast is gold. Because gold offers a low correlation to traditional asset classes and has historically shown positive risk-adjusted returns, financial advisers can use it to dampen the volatility of client portfolios and limit negative outcomes.

Client portfolios across risk tolerances have struggled in the first quarter as both stocks and bonds fell at the same time. Moreover, the more fixed income clients had in their portfolio, the worse off they tended to fare. This impacted advisers’ most conservatively positioned clients, who relied on fixed income to provide the counterbalance to stocks as it had for decades (and even did in 2008!).

As we continue to face headwinds like war, rising interest rates and inflation, the old playbook may need a revision and advisers may benefit from shifting allocations within both their fixed-income and equity exposures, as well as introducing alternative asset classes like real assets and gold.

Allison Bonds is a managing director at State Street Global Advisors and head of the private wealth management channel for the U.S. SPDR ETF business.