Investors need to rethink asset allocation and hedging strategies given that the asset classes most likely to provide the best defense against a downturn in risk assets have changed due to fluctuating market and economic conditions.
For example, for the period between the global financial crisis (GFC) and 2020, before Covid, managing downside risk in portfolios meant focusing on growth slowdowns. Today, risks are coming from multiple directions – including high inflation, stagflation and low growth, according to Adam Marden, portfolio manager, macro and absolute return strategies at T. Rowe Price, and co‑portfolio manager of the firm’s Dynamic Global Bond Strategy.
As a result, he believes energy and some other commodities have become better diversification tools for the inflation‑related risks in the current environment.
“In aggregate, you have geopolitical, industry structure, management incentive and secular power tailwinds for these sectors,” said Marden. “These factors have created a much more defensive structure than the crazy beta plays that commodities were previously.”
Cash has also risen in the pecking order because of the relatively decent yield on offer, along with its high liquidity.
At the same time, investors should look beyond asset allocation, and at potential ways to more efficiently hedge risk exposure and limit downside within their portfolio.
Notably, with elevated market volatility during periods of prolonged downturns in risk assets, Marden said strategies that benefit from higher volatility will always be defensive.
Selective in equities for a defensive stance
Within the equity universe, Marden believes the healthcare sector has the potential to outperform in a broad‑based risk downturn. He points to a combination of known secular tailwinds from ageing populations, to the more positive cyclical backdrop in sectors such as healthcare tools, to the supportive industry structure in biotech.
“[Healthcare] a very defensive area relative to all asset classes as it doesn’t get hurt nearly as badly as Treasuries or other equity sectors by inflation,” Marden explained.
Yet as is the case with commodities, investors need to be selective. In healthcare, for instance, regulatory issues add a nuance to the sector and make strong fundamental analysis of individual companies essential, he added.
Other sectors within equities to potentially consider for a defensive play include utilities, although Marden urges caution given the power demands stemming from artificial intelligence (AI) have led to a speculative valuation premium that DeepSeek’s arrival exposed. “This would cause utilities to lose some of their diversification benefits in an inflation‑driven sell‑off,” he added.
He has a similarly skeptical view about consumer staples. While acknowledging their ability to provide a defense in all environments, he also sees the sector as historically needing to trade at a relatively cheap valuation to the overall market to be of benefit to portfolios.
Shifting backdrops change defensive value
Investors also need to consider the extent to which those asset classes that have been defensive stalwarts over the years are changing.
While short-maturity US Treasuries are widely regarded as an effective diversifier for growth risks, and can help manage a portfolio with equities as well as high yield bonds or bank loans, Marden said an inflationary environment poses downside risk to holding short‑term Treasury debt due to the duration.
On the flipside, short Treasuries now provide decent yield to compensate for that risk, he added.
The same can’t be said for the long end of the US Treasury yield curve. In Marden’s view, that was the perfect hedge post‑GFC amid low rates and inflation. However, Treasury supply dynamics are negative today with the government’s large budget deficit and the possibility of a growth shock that triggers higher spending.
“I don’t think long Treasuries present many defensive characteristics today unless we see a major shift down in growth and inflation levels to what we experienced between the GFC and the start of the pandemic,” he added.
Dollar dilemma
From a currency perspective, many investors and commentators still point to the US dollar (USD) as the market’s safe-haven currency.
Yet the consistency of the USD’s defensive performance has come during a period of US exceptionalism – which is now under threat. “If that narrative flips, the USD’s defensive characteristics could erode quickly as investor demand for other currencies grows,” said Marden.
