How can portfolios enjoy the summer without getting caught in the heat?

Summer has been in full swing for several weeks, and each in our own way, we are all trying to keep the heat at bay. Markets face a similar challenge, though this can be an especially delicate balancing act.

The problem is that when investors leave for the holidays, liquidity often goes with them, leaving markets thinner, more brittle and more exposed to sudden moves. This vulnerability warrants particular attention given that risk assets are entering the summer period after several years of strong gains. Momentum has favoured the winners, positioning has grown increasingly crowded, and parts of the market now offer little margin of safety. There is also no shortage of grains of sand that could find their way into the market’s machinery.

Kevin Warsh wants a Federal Reserve (Fed) that is more flexible - and a little less predictable. The US midterm elections could throw fresh sand on Donald Trump’s agenda. In China, consumers are keeping their wallets shut, while youth unemployment is climbing again. In Japan, the yen is exposed to a carry-trade¹ unwind as volatility picks up across currency and bond markets. Add to that elevated financial leverage, recurring tensions around the Strait of Hormuz, and a heavy wave of issuance soaking up an ever-growing share of market liquidity.

So how should portfolios be positioned while investors head for the beach, or the mountains?

One option is to buy credit protection. Akin to insurance for the portfolio, you pay a known premium, and the cover pays off if spreads widen or a credit event hits. The iTraxx Crossover, for example, provides a liquid hedge on a basket of European high-yield companies.

With credit spreads already tight and market complacency running high, there is not much room left for further compression. That makes protection look attractively asymmetric: the cost is limited and visible at the premium paid, while the payoff can be substantial if markets hit a rough patch.

A second option is to give gold a place in the portfolio again. After retreating from its summit, and as investor positioning has become less crowded, the entry point looks more attractive. Gold could also regain altitude if markets scale back their most aggressive expectations for the Fed.

Defensive currencies are another place to look. The Swiss franc still appears expensive over the long run, but less so than six months ago. In real effective terms, it has weakened, and it failed to behave like much of a safe haven during the latest geopolitical shocks. That underwhelming reaction may be precisely the opportunity. Unlike more crowded hedges, the franc does not appear to be pricing in a full-blown panic. Sometimes the best shelter is the one the crowd has not rushed into.

Equity options provide a final line of defence. They allow investors to stay invested while setting a clear floor under potential losses. The cost is limited to the premium paid, while the protection becomes more effective as the sell-off deepens. They are particularly useful in markets that are expensive, highly concentrated and marked by low correlation between individual stocks.

Protection, of course, comes at a price. For gold, the cost is the income forgone: bullion pays no yield, while cash currently earns around 2.5%. For a euro-based investor buying Swiss francs, the main expense is the interest-rate differential, which translates into a negative carry of roughly 2.25%² (shown in red on the chart). For the iTraxx Crossover, the spread provides a useful guide for the annual cost of protection: at 245 basis points, the bill comes to about 2.45% a year (shown in green).

Hedging isn't hard, it’s expensive.

That is why assets that can provide shelter while still generating a positive carry are particularly valuable. The US dollar is one such example as shown by the yellow line on the chart.

Traditional government bonds can provide effective protection against a disinflationary demand shock. They are much less reliable, however, in the face of an inflationary supply shock, such as a closure of the Strait of Hormuz. Larger fiscal deficits and rising public debt also reduce their potential to rally when growth slows.

Cash protects nominal capital but not purchasing power. And while the dollar remains a safe-haven currency, it is hardly immune to abrupt shifts in US policies. In markets, even umbrellas come with weather risk.

In this environment, we favour real yields, particularly through inflation-linked bonds. They offer positive income after inflation, help preserve purchasing power and provide a more balanced defence against two very different risks of weaker growth and of persisting inflation.

We also see value in long yen positions. The currency still carries a cost, although that burden has eased in recent years, as the purple line shows. More importantly, years of yen weakness have fuelled a large build-up in carry trades. Higher Japanese yields, intervention by the authorities or a sell-off in risk assets could force those positions to unwind and send the yen sharply higher.

Alongside these positions, we tactically add more expensive forms of protection, including credit-index CDS and equity-index options.

The goal is not to eliminate every bump in the road. It is to ensure portfolios can ride out the turbulence.

A good hedge does not eliminate risk; it prevents a temporary shock from becoming a permanent loss. Above all, it allows investors to stay invested, keep some dry powder and avoid forced selling once liquidity has vanished.