Downside risks always exist for every investment portfolio, leaving investors with the difficult but necessary task of preventing the predominance of such risks.
In building a basket of investments, many rightfully prioritize the optimization of returns, selecting a mix of securities that provide a near-guaranteed gain.
To exemplify, in equity investing, one could pick some volatile but underpriced fundamentally sound stocks that are diversified across various sectors, and then include a few other viable stocks that have very low price volatility to serve as a hedge; hence, creating an equity portfolio that should yield some decent returns in the long term. However, the Achilles’ heel for most portfolios are the emanating macroeconomic headwinds that often blindside investors.
Notably, GDP growth and inflation are two dominant macro variables in which an adverse movement could have shriveling impacts on asset prices, and by extension, portfolio performance. Nonetheless, unfavorable changes are a given, and hedging is the defensive strategy usually deployed by savvy investors to insulate themselves from macroeconomic headwinds.
The simultaneous occurrence of rising inflation and unemployment in a stagnant economy, usually referred to as stagflation, is a dire economic dilemma that was deemed impracticable up until the 1970s energy crisis, and seldom witnessed in developed economies in modern times. However, this unfavorable economic situation has been woven into the fabric of Nigeria’s economic reality, making it imperative to mitigate the possible impacts of rising inflation and plummeting growth on portfolio performance. Most recently, inflation printed at 18.12% (April 2020), the unemployment rate stood at 33.3%, while the economy is struggling to climb out of a double-dip recession (2016 and 2020).
Inflation – the silent thief
Inflation takes money from your pocket, and it does not matter whether your funds are domiciled in a savings account or an investment. Irrespective of where those funds are, their real value diminishes. Hence, the struggle here is finding returns that will outpace the rate of inflation, so as to keep real returns in the green. Currently, Nigeria has an inflation rate that outpaces the yield at the long-end of the FGN bond curve and the long-term equity market return, but the persistent uptick did not catch the market by surprise. Inflationary drivers were apparent, and hedging became of essence.
When faced with an upsurge in the rate of inflation, both the fixed income and equity market would give room for a bearish dominance. The first-order effect of a rise in inflation manifests in both the fixed income and equity spaces. For the fixed income market, inflation triggers a reprising of risks, causing yields to inch up.
If yields are going up, then prices are falling. The start of this year was a case in point, as the persistent rise in inflation contributed to the retracement of fixed income yields. With yields so depressed last year that we had the rates at the short end of the treasury bill curve nearing zero, a lack of appetite for fixed income securities was an apparent outcome.
For the equity market, inflation causes the cost of production to rise, which in turn eats into the bottom-line of companies that are unable to pass down these cost increases to their customers. The second-order effect of the rise in inflation is seen in the equity market, as rising rates in the fixed income space would disincentivize equity investment.
The rationale behind this relationship hinges upon the risky nature of equity investments, as investors tend to rationally gravitate away from a variable return and high-risk investments when the risk-free rate gets attractive. The equity market selloff witnessed thus far this year has this to blame.
Recession – the daylight robber
The impact of a recession is obvious, particularly on variable return asset classes. When an economy shows signs of going into a recession, there is usually a massive selloff in both the equity and fixed income markets. Such was witnessed in 2016 and 2020. However, after holding on to the cash for some time, people tend to gravitate towards less risky assets later in the recession, in fear of the potential losses that could be suffered in the equity market. Take 2020 as a point of illustration, as equity and fixed income prices crashed significantly between March and June, after which we saw yields decline while equity prices stayed flattered up until October. Hence, a recession poses a long-term risk to the equity market performance, and prices could stay depressed for extended periods.
Hedging against inflation and recession simultaneously
The only way to beat inflation is by ensuring that your investments yield returns in excess of the rate of price increase. However, one must proactively anticipate a persistent rise in the general price level to properly position themselves to weather the headwind. An average Nigerian investor has a passive portfolio that consists of fixed income securities and equities, and this constitutes a problem as both asset classes do not hold up well against inflation. When faced with recession, everything turns to ash in the first instance, but the downtrend lasts longer in the equity market. However, there are usually sectors that remain shielded from the adverse impact of the overall economic decline, as they are insulated from the dominant downside risks that pose a threat to the economy.
Hence, we propose three strategic steps to insulate a portfolio from inflation and recession:
Step 1: Reduce overall fixed income and equity holdings – If an increase in the rate of inflation and an economic recession are anticipated, there could be a knee jerk bearish reaction in both the local fixed income market and the equity market. Hence, there may be a need to reduce one’s positions in both markets. However, one could redeploy some cash to the fixed income market when yields have reached their resistance level, as equity investors consider moving into safer asset classes.
Step 2: Introduce hedging asset classes – The general hedging strategy is to find safe haven assets, and these are usually dollar denominated. One major trigger for a recession is the decline in the price of crude oil, which is the key source of FX for the economy. Hence, the past recessions in Nigeria have been accompanied by the depreciation of the naira, making Eurobonds a suitable hedge, as it is unaffected by the local rate of inflation and also guarantees some additional returns from exchange translation. Also, commodities like gold have historically served as a crisis hedge globally, and also offer the additional incentive of hedging against our local currency depreciation. There are numerous other commodity investments, but vehicles to access this investible asset class are limited in Nigeria.
Step 3: Rejig your equity strategy – There are sectors that have demonstrated some sort of resistance to inflation and recession, and the equity segment of the portfolio can be restructured to include stocks from such sectors. The banking sector in Nigeria strangely happens to serve as a hedge, favored by rising yields as it improves their spread, and also demonstrates adaptive tendencies to changing economic climates. Also, the industrial sector is positively poised to help hedge a portfolio against recession and inflation, as economic downtrends trigger higher infrastructure spending, while the rise in prices are easily passed down to the customers. Agricultural stocks also benefit from an economic downturn and a fast-rising inflation rate, given the low demand elasticity, as well as the high private and public sector attention the sector gets in recessionary periods as it is considered a possible alternative for oil.
