Safe Haven Investing

[Danielyan Garay]

Theycan be one of the ways that you can diversify your portfolio to protect against risk. Safe havens offer stable returns during unstable times. Though their low risk comes with lower potential returns, they can provide stability when high risk investments stumble.

Inflation erodes the purchasing power of investments, even safe havens. Of particular concern would be a rising inflation rate concurrent with a drop in investment account value. Even though safe havens may not drop as much as some other investments, they still suffer from inflation's power to eat away at value.

It depends on what you want in an investment. A safe haven is a lower risk (lower return) investment that can help diversify a portfolio and offset to some degree the greater risk of investments that offer the potential for higher returns. Having both types of investments makes sense for many investors.

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A safe-haven asset is a financial instrument that is expected to retain, or even gain value during periods of economic downturn. These assets are uncorrelated or negatively correlated with the economy as a whole, which means that they could appreciate in the event of a market crash.

Not every safe-haven will have all of these characteristics, so investors have to make a judgement about the most suitable safe haven for the economic climate. It is important to remember that what makes a good safe-haven for one market downturn may not show the same results in another, so investors have to be clear about what they are looking to gain from using safe-haven investments.

In times of financial crisis, assets that are viewed as safe-havens tend to outperform the vast majority of markets. Although safe havens are primarily used by investors to protect the value of their portfolio, it is important for traders to be able to identify safe-haven assets, and use this understanding to anticipate price movements and implement their own strategies.

There is no definitive way to trade the patterns of safe-haven assets, as it all depends on your motivation. But whether you are looking to take advantage of price movements or adjust their own positions to protect themselves from falling prices, it is crucial to understand the prevailing market sentiment surrounding safe-havens.

When people think of a safe-haven, they will most likely think of gold. As a physical commodity, the price of gold is not often influenced by the decisions of central banks on interest rates, and unlike paper currencies, its supply cannot be manipulated by actions such as printing.

Perhaps the strongest example of gold as a safe-haven was following the 2008 global financial crisis. The influx of investment caused the price of gold to rise by nearly 24% during 2009 alone, for example, and it continued this upward trajectory into 2011.

Post-World War II, the Japanese economy was restructured, which enabled it to catch up with other global economies. The Bank of Japan (BoJ) became highly respected and the yen was established as a major global currency. Despite continued interventions from the government, the liquidity of the yen has continued to attract investors in times of financial distress.

Another part of the reason that the yen continues to act as a safe-haven during periods of market turbulence, is because everyone believes that it is. In a similar way to gold, it has become a self-fulfilling prophecy.

Defensive stocks describe the shares of companies that are involved in providing goods and services such as utilities, consumer staples, food and beverages, and healthcare. They are considered safe-haven assets because they are likely to remain stable due to the constant demand for their products, even in periods of economic instability.

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Gold is often regarded as one of the most popular choices to invest in during times of economic instability. Historically, the value of gold increased significantly during the 2008-2009 Global Financial Crisis. It gave investors a return of approximately 20% between 2008 and 2009.

The high liquidity associated with gold makes it an easy investment for individuals to buy and sell. Unlike other assets, gold is also an important safe-haven investment because it is a physical commodity, so it will not be impacted by economic factors, such as currencies, interest rates, and inflation. Therefore, investors see gold as a safe investment because it can still retain its value even in the midst of inflation.

A government bond is a fixed-income financial instrument. Bonds are issued by the government or corporations when they want to raise more capital. They are similar to a loan in the sense that an investor would lend their money to the government, and the amount would be paid back by the government at the maturity date.

A government bond is a safe-haven asset because it is considered to be risk-free and has low volatility. This is because investors will be paid back the principal, along with any outstanding interest at the date of maturity. Investors also prefer to invest in government bonds because the government is considered to have high creditworthiness, which also provides more security and confidence for investors.

They are safe-haven investments because there will always be a constant level of demand for these products regardless if there is economic turmoil. For example, people will still need access to gas, water, electricity, and healthcare, even when the economy is performing poorly.

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Developed market sovereign bonds are arguably the most canonical example of a safe-haven asset because of their lower realized volatility relative to stocks and the high expected creditworthiness of their issuers (developed market governments). However, it is no secret that equities and bonds have significantly increased their correlation recently, including during the 2022 stock market plunge.

Before looking at 2022, it is worth noting the jump in correlation between equities and bonds that occurred as the Covid crisis began in 2020. This higher correlation also had a steep drop-off when that shock rolled off one year later. Since that time, correlation between equities and bonds has steadily risen to 0.44, higher than it has been since 1997.

During the 2022 stock market plunge, our Equity factor was down -22.94%, while our Interest Rates Factor was down -12.13%. This is not the diversification investors were presumably hoping for from two historically negatively correlated factors, especially for those implementing a risk parity strategy.

Given that we are viewing the non-USD currencies relative to the Dollar, it was highly unlikely for all three of our safe-haven currencies to outperform at the same time, but nonetheless, over this period the Dollar was the clear winner, up 17.76%.

In every introductory finance class, you begin with the notion of a risk-free investment, and the rate on that investment becomes the base on which you build, to get to expected returns on risky assets and investments. In fact, the standard practice that most analysts and investors follow to estimate the risk free rate is to use the government bond rate, with the only variants being whether they use a short term or a long term rate. I took this estimation process for granted until 2008, when during that crisis, I woke up to the realization that no matter what the text books say about risk-free investments, there are times when finding an investment with a guaranteed return can become an impossible task. In the aftermath of that crisis, I wrote a series of what I called my nightmare papers, starting with one titled, "What if nothing is risk free?", where I looked at the possibility that we live in a world where nothing is truly risk free. I was reminded of that paper a few weeks ago, when Fitch downgraded the US, from AAA to AA+, a relatively minor shift, but one with significant psychological consequences for investors in the largest economy in the world, whose currency still dominates global transactions. After the rating downgrade, my mailbox was inundated with questions of what this action meant for investing, in general, and for corporate finance and valuation practice, in particular, and this post is my attempt to answer them all with one post.

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