Last hedge standing

  • BlackRock

With traditional hedges not working as effectively, portfolio manager Russ Koesterich discusses how the dollar may serve in that role.

This year, investors have had to manage a unique environment when it comes to building portfolios: another strong year for stocks but a dearth of hedges. As I’ve discussed in previous blogs, the traditional risk mitigants, notably Treasuries, have become either less effective or outright counterproductive.  This new dynamic requires a more creative approach to managing risk. Interestingly, part of the new arsenal is the most generic of all asset classes: the U.S. dollar.

Returns yes, hedges no

As most markets continue to grind higher, it is increasingly difficult to find assets moving in the other direction. Since the start of the year, U.S. Treasuries are increasingly co-moving with equities. (see Chart 1). Nor is the phenomenon limited to bonds. Gold has been trading like a growth stock, with daily movements driven by changes in real, i.e. inflation-adjusted bond yields.

Correlation of bond and equity returns

This chart displays the rolling 90 day correlation of US 10Y Treasury and S&P 500 equity returns beginning in 1985. Recent data points display that U.S. Treasuries are increasingly co-moving with equities since the beginning of 2021.

Source: Refinitiv Datastream, chart by BlackRock Investment Institute, as of 7/13/21.
Note: The line shows the correlation of daily U.S. 10y Treasury returns and S&P 500 over a rolling 90-day period. Past correlations are no guarantee of future correlations.

In the absence of traditional hedges, investors can look to alternative strategies, including volatility as an asset class and using high quality equities to dampen overall portfolio volatility. The other potential solution is to focus on the dwindling list of assets that are demonstrating a negative correlation with stock prices.

Go your own way

One key characteristic that distinguishes an efficient hedge is a tendency to rise when stocks are falling. In recent quarters the dollar has been doing just that. Looking at the past few years of data, weekly changes in the Dollar Index (DXY) have had a -0.54 correlation with weekly changes in the S&P 500 Index.

Part of the explanation for the negative correlation lies in what has been driving both the dollar and equities: interest rate volatility. Since the start of the year the dollar has been more likely to rise when bond market volatility is rising. At the same time, rising bond market volatility has increasingly been correlated with higher equity volatility. Put differently, the dollar and equities are frequently responding to the same underlying factor, but in different directions.

Dollar bears could rightly point to the numerous reasons to be negative on the dollar. Higher inflation ultimately erodes purchasing power. Fiscal policy is increasingly debt financed, with the highest buildup in government debt since the second world war. That said, in the near term the dollar is likely to be driven by more prosaic concerns, notably rate markets and fund flows. With the Federal Reserve likely to begin withdrawing accommodation ahead of most other central banks, the dollar may be firmer than many expected at the start of the year.

Long dollar to manage risk

The current regime necessitates an evolving approach to building portfolios. There is no simple substitute for U.S. Treasuries, which offered both an efficient hedge and income. In the absence of a reliance on U.S. Treasuries, a larger dollar position, either through owning more U.S. assets and/or hedging out foreign currency exposure, may be one of the simpler ways to manage market volatility.

Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and the lead portfolio manager on the GA Selects model portfolio strategies.

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July

 2021 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Russ Koesterich, CFA, JD
Russ Koesterich, CFA, is a portfolio manager for BlackRock’s Global Allocation Fund and lead portfolio manager on the GA Selects model portfolio strategies.
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