Three, as we’re often told, is the magic number, which may go some way to explaining why conventional asset allocation has long been framed as a balance between return, risk and diversification.

In reality, this trio exists within a dense web of portfolio construction that operates with assumptions about how assets will perform and how they might behave when markets are under stress. Even well-constructed portfolios rely on hundreds of such estimates, each hewn with a degree of uncertainty. The challenge for long-term investors is that these uncertainties can sometimes rise to the surface during intricate moments such as periods of market disruption, when capital preservation becomes a pressing concern.

These issues have prompted asset managers to try other approaches to asset allocation. The principal alternative model focuses on the potential declines of each asset in a worst-case scenario. The analysis of possible declines, known as “maximum drawdowns”, has an intuitive underpinning: investors are naturally more concerned by performance in extreme market downturns than in the normal, daily ups and downs. Asset managers, therefore, have one eye on the optimal asset allocation using conventional thinking about risk and return, and another on the likely behaviour in a crisis.

As a result, investors can often place a premium on assets that not only offer attractive risk-return characteristics, but that could be relied upon when markets come under pressure. Still, the landscape of safe haven assets is still shrinking. For much of modern financial history, government bonds played a stabilising role within portfolios. It was a position only reinforced after the Global Financial Crisis (GFC), as central banks bought large quantities of government debt to support prices and suppress yields. While it was sometimes effective as a policy response, the current era of quantitative easing has fundamentally altered the pricing of government bonds, and perhaps weakened their traditional function as portfolio safe havens.

Central bankers may have hoped that governments would use the lower cost of debt to stimulate their economies after the GFC, but in many cases politicians instead opted for austerity and lower debt burdens. This meant central bankers were left standing alone in their quest for economic growth. This period has sometimes been termed as the “new normal” of low economic growth, sustained by ultra-low interest rates. An unexpected benefit for investors was that, having inadvertently discovered a tool for enhancing investor sentiment, central banks were now expected to use it to calm distressed market conditions. During the past 15 years, many surges in market volatility has led to the expectation that central banks will cut rates. Any central banker failing to do so would be risking a market meltdown.

It was during the pandemic that governments and central banks worked together to stimulate the economy. Seized by the fear of a near-total economic shutdown, central bankers slashed rates and governments went into overdrive with spending, support and stimulus of various kinds. Investors now had two reasons to celebrate because it was the stimulus for high government spending and low rates, which led to the stock market boom of 2021 (and the subsequent bust in 2022). Government and central banks working in tandem is a powerful combination. Markets were transported back to the 1970s, when governments controlled central banks and boom-bust cycles were the norm.

Ultimately, government spending is a finite resource and funded by taxes which can sometimes be, politically, controversial. Government bonds were sold off after the pandemic, raising interest rate paid on new issues of debt. Thus, higher interest rates make high levels of government debt less sustainable. Since then, however, rather than returning government finances towards long-term norms, governments have continued to spend. This has exacerbated the sell-off in bonds, especially at the most vulnerable longer maturities. The chart below illustrates this trend in terms of 30-year bond yields.

In the face of long-term slower growth in the developed world, it was up to higher taxes to resolve this situation. Raising taxes is, again, politically unfeasible, leaving bondholders as the last line of defence. The previously reliable safe haven of remains unusually precarious. If we look at the following chart, it shows the performance of selected government bond markets during equity market drawdowns since the GFC.

Asset allocators increasingly doubt that the inconvenient political and fiscal trends post-pandemic can be contained. But that's not all. The shift away from globalisation to domestic production might often lean away from the lowest-cost production and the lowest-cost supply chain. Moving from a most-efficient model to a most-resilient model has implications for inflation, and most economists expect it could lead to structurally higher, and more volatile, inflation.

The result is that shares and bonds are increasingly moving in the same direction, diminishing the stabilising role government bonds once played in diversified portfolios. This was clearly visible last year, when German government bonds began to behave differently from other traditional safe havens, particularly US Treasuries. Historically, German bunds have been among the most reliable defensive assets in Europe and tended to move broadly in line with US government bonds. That relationship dissipated when Germany announced looser fiscal rules to fund higher defence and infrastructure spending, pushing bund yields sharply higher. As a result, correlations between German bonds and other government debt collapsed, with the relationship between 10-year German bunds and US Treasuries falling to its weakest level in a quarter of a century.

This is important for investors to note because assets that once provided reliable protection in periods of stress can no longer be expected to do so. When traditional safe havens do move unpredictably, or in tandem with risk assets, the ability of portfolios to absorb shocks can be greatly reduced.

Most asset allocators may still hold government bonds in portfolios because they might aim to have some safe haven characteristics in the case of market shocks. However, as their expected returns trend lower, and their correlations with other assets become less dependable, that trade-off becomes more difficult to justify. Allocations to government bonds will then decline, reinforcing the issues facing governments, central banks and the investment community.

Asset managers outside the US have, historically, been able to rely to some extent on currencies to control drawdowns. The Euro Crisis in 2009 was a good example of this, as it came under extreme pressure and ultimately fell around 20% against the US dollar. That was a boon for Europeans holding unhedged, dollar-denominated assets in portfolios, whose prices appreciated due only to exchange rates. The pound’s value against the dollar tends to track the Euro quite closely, and sterling-denominated investors were rewarded similarly, with a 15% decline in the pound against the dollar.

For European investors, exposure to the US dollar comes mainly through holdings in US equities. That exposure has increased as US markets have outperformed others, to the point where roughly two-thirds of global equity indices are now dollar-denominated. Investors can also build dollar exposure through unhedged US bonds, dollar-denominated emerging market debt, or emerging market equity indices that are calculated in dollars.

As a result, growth-oriented portfolios can easily carry 70% or more exposure to dollar assets. In practical terms, this means that a 20% fall in an investor’s local currency against the dollar may be seen to lift portfolio values by around 14%, even if markets are otherwise under pressure. Currency exposure can therefore act as a meaningful stabiliser in periods of stress. This was evident during Brexit, when UK investors with globally diversified portfolios benefited from the sharp fall in sterling, limiting losses despite a significant decline in domestic equities.

The charts below show how the euro and pound sterling have moved against the US dollar during various market crises, including the Great Financial Crisis, Brexit, the pandemic and, more recently, Liberation Day. In each case, the US dollar gained value against both currencies as the landscape unfolded.

The recent weakening of the dollar under the current US government presents a significant challenge for asset managers. As with government bonds, the risks of holding the exposure outside of a crisis environment are growing, making high weightings difficult to justify. This means another potential safe haven has fallen by the wayside.

Other currencies also have haven characteristics, notably the Swiss franc and, historically, the Japanese yen. The chart below shows the performance of the US dollar, the Japanese yen and the Swiss franc during equity market drawdowns since the GFC.

Precious metals have also had to be taken off the list of potential safe havens, thanks to their increasing popularity. The price chart for gold currently resembles the early days of cryptocurrencies. Gold’s potential for unexpected price volatility has increased and the likelihood of it surviving a market downturn has diminished. The chart below shows the historic volatility of the gold price across time, and its recent surge in volatility, which was accompanied by a dramatic price decline (without any apparent catalyst).

Gold’s potential volatility may lead some to view it as too unpredictable. Moreover, it has sometimes failed to protect investors in recent drawdowns, as demonstrated by the chart below. Though performing better than equites, gold has, nevertheless, fallen during recent equity market corrections so perhaps it no longer qualifies as a reliable safe haven.

The charts above highlight the declining reliability of traditional safe havens over recent periods. Investors facing a lack of safe havens have three choices. Firstly, they can choose to expend portfolio capital on derivatives, which are seen by some to provide greater protection in a drawdown but still require specialised expertise. At Arbra, we possess these skills and have been advocating this approach for several months. It may help that the cost of protection via derivatives is also, currently, very attractive. A significant degree of protection against declines in the US equity market can be achieved at a minimal cost, making this strategy particularly compelling under current conditions.

Alternatively, investors can convert their more-risky or better-performing holdings, increasing the weight of cash (or other, low-risk assets) in portfolios. This approach might risk missing out on further, potential upside in riskier assets but, with valuations across several major asset classes having reached all-time highs on a historical basis, it’s an approach that could seem reasonable to some.

Finally, investors can decide to roll with the punches, accepting potential drawdowns and hoping for stability to return. Many investors now accept this “wait it out” approach because they expect to be bailed out of any financial crisis by central banks cutting rates and, if necessary, the introduction of government spending. This may have encouraged the high returns and valuations observable in markets today, and it’s a trend that’s become more widespread as governments across the world have rolled out stimulus programmes to protect citizens from more serious economic harm. Ultimately, however, this strategy can be very dependent on the nature of the events concerning markets, which can still be vulnerable to those "unknown unknowns" or black swan events that are prevalent in the markets.

At Arbra, we prefer to advise and direct portfolios with precision, which requires the use of derivatives or a higher-than-usual weight towards cash, all backed by solid expertise, rigorous discipline and pragmatism. Get in touch to talk about potential safe havens, portfolio allocation or any number of queries you may have concerning investments or assets.