Don’t worry, this isn’t a piece about gardening, and I’ve not morphed into Alan Titchmarsh over the weekend.
Instead, Friday’s price action prompted an interesting question; namely, what’s the hedge in the present environment?
Friday = Sell Everything
As last week wrapped up, what we saw was essentially a ‘sell everything’ day. Stocks fell off a cliff, with the Nasdaq 100 notching its worst day in a year; Govvies slumped across the board, with the front-end bearing the brunt of the pressure across DM; and, precious metals lost their lustre, as gold slipped beneath its 200-day moving average for the first time in almost three years.
This begs the question as to how one is best able to hedge equity downside in the current environment.
That’s not an especially easy question to answer, when we consider not only what that environment looks like, but also how traditional risk-off hedges have traded since conflict broke out in the Middle East.
Traditional Hedges Aren’t Working
First, the macro backdrop. You don’t need me to tell you that, right now, said backdrop is clearly an inflationary one, at least in the near-term, as the Strait of Hormuz remains closed, for all intents and purposes, exerting continued upward pressure on commodity prices, even if the likelihood of those pressures broadening out, or of second-round inflationary effects emerging, still seems somewhat limited for now. Of course, all this, as well as any central bank tightening that is delivered, will ultimately culminate in a sizeable negative demand shock, though the market is unable, or unwilling, to price this for now, focusing instead on whether, and when, the conflict will come to an end as the first priority.
That, rather handily, helps explain why Govvies aren’t working as a hedge right now. In an environment where CPI, stateside, is heading north of 4% YoY, and where central banks across G10 are pulling the trigger on rate hikes, buying the front-end is a very difficult case to make. Even if one believes, as I do, that the market has gone too far in pricing rate hikes, fading that pricing is tough unless and until clarity is obtained either on where inflation will likely peak, and/or on central bank reaction functions, as the experience of early-March taught STIRs traders across the globe.
As for other hedges, the long-end of the curve is similarly unattractive for those operating over a shorter-term time horizon, given those inflationary risks, though the benchmark 30-year Treasury yielding 5.00%, or more, is undoutebdly attractive for those able to ride out the short-term turbulence that we’re currently seeing.
Precious metals, meanwhile, can’t realistically be considered a risk-off asset at this point, in my view. A cheap shot would be to say that retail have ruined both gold, and silver, but it’s an argument that holds water, given the speculative mania that took over both at the start of the year, and the near tick-for-tick perfect correlation that we now see on display between gold, and other high-beta assets such as equities, the AUD, and even crypto.
So, What Might Work?
So, if one wants to hide out from a proverbial market storm, what options do they have?
Frankly, the only real option right now is to hide out in cash, more often than not in the form of buying the greenback, and waiting for the storm to pass. This haven demand adds another aspect to the USD bull case, which was already a robust one considering the lesser degree to which the US economy is exposed to higher energy prices, as well as a resurgent ‘US exceptionalism’ narrative, fuelled on by last week’s PMIs, and of course Friday’s blockbuster May jobs report.
For those not wishing to hide out in the buck, the best option may well be to do nothing at all. Short-run choppiness is a feature, not a bug, of any and all bull markets, and despite the sizeable nature of Friday’s equity sell-off, this is clearly still such a market. In fact, the fundamental bull case is still a very robust one indeed, with both earnings growth and revisions solid, as well as economic momentum remaining robust. It is undeniable that the market has come a long way (30-odd%) from the March lows, and has moved in a straight line for the majority of that period. As such, a ‘pause for breath’, in the form of a modest pullback that we currently see, is no bad thing whatsoever, as such a pause will permit positioning to become much cleaner, likely leading to a more robust rally over the medium-run, unless and until those aforementioned fundamental factors underpinning the market begin to change.
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