Trouble in Paradise? The realities of Safe Haven Investments
Monday 16 July 2018
When we hear about market activity and where investors are placing their money, the terms ‘hedging’ and ‘safe havens’ are frequently mentioned, especially in times of market volatility. They are often described as safety precautions used by investors to protect their money, but what does this mean, and can anything be deemed a safe or ‘risk-free’ investment when everything from political elections and corporate news to royal weddings and the weather can affect market conditions and performance.
What is a safe haven investment?
“A safe haven is an investment that is expected to retain or increase in value during times of market turbulence” (I). Essentially, safe havens are used by investors, institutional and private alike, to limit their exposure to loss in the event of a slump in the market. For the most part safe havens do their job well and help protect investors, however it is important to remember that what appears to be a safe bet in one downturn may not necessarily be safe in another.
Therefore, the evaluation of what classifies as a safe haven can vary. Some examples of safe haven investments are; gold, government bonds, Japanese yen, Swiss franc, cash and defensive stocks, each of which will be explained in greater detail later.
Market participants use safe havens as a form of safety net against loss of investment. Nearly all investors will balance their portfolio across multiple sectors, companies or markets in the hope that the overall fund will not be affected if one of these sectors performs badly.
In a similar fashion safe havens are used to protect the overall portfolio so even if the market as a whole is performing badly, the safe haven investment will help them ride out the storm and protect at least part of their investment. A recent example of when interest in safe havens surged is during the historic US / North Korea summit in Singapore. Japanese yen rallied shortly before the summit as investors paused, unsure of the direction the meeting of Trump and Kim Jong-un would take.
The uncertainty meant investors did not know where to place their money therefore they looked to a safe haven to limit their exposure if the meeting turned sour as yen would be unaffected regardless of the outcome. Safe havens are favoured as a protective measure as they are meant to be unaffected by market conditions unlike other products such as equities. However, to understand why they are considered a safe bet we first need to explore what they are and if indeed they can be classed as risk free.
Gold is one of the most popular safe haven investments. It is a physical asset that cannot be printed, unlike cash, or affected by interest rates and market conditions. Gold’s trading history goes back to ancient times when its beauty and association with nobility meant that it became a natural commodity for transactions (II).
This has led to it upholding its value throughout both market volatility and calm and it being perceived as a safe haven investment. When Britain decided to leave the EU the price of gold soared. Why? It was because investors knew that it would be unaffected by the surrounding chaos. If we go back even further, we can clearly see gold’s price spiking during troubling times.
This graph (II) shows gold peaking over 1976-1980 due to the oil crisis and surging during the financial crisis of 2008 and its performance compared against US CPI, a measure of the price consumers pay for a standard basket of goods.
However, the price of gold itself can be volatile as it is driven by what the next person is willing to pay for it. This raises the important distinction between price and value and when investing in gold the price will be tangible and can be influenced by market forces whilst the value will be more conceptual (II).
Therefore, those who opt to invest in gold need to be prepared for a bumpy ride as gold prices can rocket but bought at the wrong time, cause investors to lose money. Gold bears no annual yields or income and so would not be considered suitable if this type of investment were required.
Government bonds provide another method of hedging against risk and are a safer investment as their debt securities are underwritten by government. US Treasury bonds are viewed as the most superior as they are considered good value for money in comparison to other countries such as Japan or Switzerland where yields are negative.
Furthermore, bonds are rated by credit agencies therefore an investor can choose the level of risk they want to engage in before purchase (III). While it can be argued that government bonds are a safer form of investment than more risk prone equities they are not without their pitfalls. The fear for investors is that whilst they do receive a return on their initial investment this value could be significantly less than investing in the equity markets.
There are three main forms of risk when investing in government bonds, interest risk, inflation risk and currency risk (IV). Interest risk is the potential that rising interest rates will cause the value of your bond to fall. This is because of the effect that high interest rates have on the opportunity cost of holding a bond when you could get a better return elsewhere.
Inflation risk involves rising inflation having the potential to decrease the value of your bond If the rate of inflation rises over the coupon rate of the bond, then the investment will lose, rather than gain, money. Index-linked bonds can help mitigate against this. Currency risk only applies to investors who have chosen bonds not in their native currency as fluctuating exchange rates may see the value of the investment drop.
The Swiss franc is a sought-after investment as the stability of the Swiss government and its financial system is considered consistent. As a result of these factors there is a surge in demand for Swiss francs during periods of market turmoil.
This was evident during the financial crisis of 2008 and the European debt crisis in 2011 (V). Switzerland has a low-volatility capital market and virtually no unemployment which leads to a higher standard of living and trade balance figures which are in positive equity.
The country is also independent of the EU which can mean, depending on the negative political or economic events that occur within the region, that it can remain impartial. Despite this, during times of low financial stress, factors such as inflation can influence the value of the Swiss franc in the same way as other currencies.
In recent months the Swiss Franc has come under pressure and fallen to its weakest level against the euro since Switzerland’s central bank abolished its cap to the single currency over three years ago (VI). Despite the threat of a global trade war and western military strikes against Syria the franc continued to drop, suggesting investors were looking elsewhere for havens.
This graph shows how the franc has performed in comparison to another safe haven, the Japanese yen, in the first quarter of 2018. It clearly shows a decline in the price, and therefore the demand, of this so-called haven currency (VII).
Despite this Thomas Jordan, Swiss National Bank Chairman, claimed US protectionist tendencies posed a risk to the Swiss economy and could generate renewed interest for the Swiss franc, indicating investors may not be done with this haven just yet (VIII).
Like the Swiss franc, Japanese yen is another safe haven currency popular with investors. If we think back to the summer of 2017 when Pyongyang was conducting their latest ballistic missile tests safe haven assets surged – including the yen which hit its highest level since April that year.
The gains were all the more impressive given that a rocket flew directly over Japan. So why is the yen considered so safe, even with the threat of overhead rockets? It appears to be a combination of factors. Japan has one of the largest economies in the world, with one of the highest CGP among nations, and it is also one of the largest exporters, in terms of dollars (IX).
Chiefly, Japan’s net foreign asset position is very significant with purchases of foreign debt tripling to 4.46 trillion yen in July 2017. This has made them the largest overseas holder of securities after China (X).
Japan has always been a large exporter and has continually exported significantly more goods and services than it imports. This has resulted in decades of current account surplus that has manoeuvred Japan into position as the next creditor to the world (XI). Japan has also been a leader in terms of low-interest rates which have been held at rock bottom for two decades. This has helped to stave off deflation and encourage economic growth.
This graph (X) shows a comparison of gold and yen and how their dips and rallies mirror one another based on market activity.
Nevertheless, concerns have been raised with regard to the high levels of debt that Japan has, although traders tend to be more comfortable with Japan’s debt as it is held almost entirely in-house by the Japanese public.
Defensive stocks comprise items that are essential to everyday life including food, healthcare, basic household items and infrastructure. Infrastructure is a sector that will primarily do better when the market is in an upswing as money being available encourages spending by consumers and on the infrastructure. Despite this, basic maintenance is required even during down-turns in the market therefore this sector should remain steady regardless of conditions.
Defensive stocks tend to perform better than the broader market during recessions. However, during an expansion phase, they tend to perform below the market. This is attributed to their low beta, or relative risk and performance to the market (XII). Well-established companies such as Procter & Gamble, Johnson & Johnson, Philip Morris International and Coca-Cola are considered defensive stocks (XII). In addition to strong cash flows, these companies have strong operations with the ability to weather weakening economic conditions.
They also pay dividends, which can have the effect of cushioning a stock’s price during a market decline. Defensive stocks will not deliver returns as good as cyclical stocks as they are less prone to volatility however they usually pay regular dividends making them stable and makes them an ideal safe haven.
Just as gold is identified as one of the original safe havens, cash is arguably the only real safe haven as returns are not impacted by stock market volatility and it is a physical asset which will always have value. One of the main benefits of cash is that it can be kept tucked away for a rainy day or kept as a safety net to fall back on.
Furthermore, if your cash is held in an institution authorised by the Prudential Regulation Authority in the UK then it will be protected by the Financial Services Compensation Scheme up to the value of £75,000 per person or per institution (III). This mitigates the risk of losing the investment if the bank or institution collapses or goes bankrupt, up to the value of £75,000 at least – once again, a safety net not a perfect solution.
This level of protection is not offered to equities and makes cash investments an appealing security option. However this does not make investing cash the perfect safe haven as inflation can adversely affect its value. Twenty years ago, £50 would have bought significantly more than it does today. If that principle were to be applied to a large pension pot, then the potential to lose a greater amount becomes apparent, as is the risk involved unless it tracks inflation.
Furthermore quantitative easing by government, which is an artificial injection of cash into the financial system, lowers interest rates and increases the overall supply of money, will affect cash value. Taking a long-term overview illustrates that quantitative easing and inflation can devalue a currency (XIII).
With this in mind can the above instruments all be classed as safe or risk free investments? During the run up to, and post Brexit, the market was driven by demand for defensive stocks and haven investments as investors feared a multitude of economic disasters. In turn this drove the price of safe havens up. Now consider, if investors are paying a higher price to ‘park’ their money, is the protection actually worth it? Are investors at risk of losing out, or is this a risk in itself? The biggest flaw it appears in havens is that whilst they are appealing in a crisis situation, they are not generally good value when the market is rising.
Overall it is safe to say that whilst havens are definitely not perfect, risk-free instruments they are definitely safer in terms of protecting investors against losing money they have already spent. An investor who chooses to place their money in the equity markets needs to take into account that their investment has the potential to lose as well as gain in value. The investor who has placed their income in bonds or gold takes a more negligible risk.
The above examples show the benefits and flaws to haven investments, however they are popular as investors flock to these in an effect to protect their wealth. The practice of using safe havens to hedge against risk has been a long occurring practice and it does not appear to be diminishing anytime soon.
So, what does the future hold for haven investments? It is difficult to predict what the next haven will be. Some argue that Chinese Yuan may become the next haven currency whilst others believe single companies can be classed as a haven if the rest of that sector is performing poorly.
One thing that does seem apparent is the safe havens referenced above are going to stick around.
Katie joined FinTrU in April 2016 through the 3rd Financial Services Academy intake, after graduating from Queen’s University Belfast with a BA (Hons) in Criminology. Katie chose to come to FinTrU because of the Academy model, which allowed for someone without a finance or economics background to build a knowledge base if they had the right attitude and aptitude.
The FinTrU Financial Services Academy is a bespoke programme, comprising intensive training in financial markets, and financial regulation with a focus on data analysis and management.
Since joining FinTrU, Katie first worked on a mini data analytics project with a leading Asset-Management firm. Upon completion Katie went on to work with a Tier 1 Investment Bank, with the UK & Ireland Corporate Broking team; within the Investment Banking Division.
As a member of the UK & Ireland Corporate Broking team Katie would provide market reports for the bank’s corporate clients, whether on a daily, weekly or monthly basis, helping to summarise the performance of the client, its peers and the wider equity markets.
Katie would also support the team on building investor targeting packs, which would help to advise corporate clients on where to source further institutional investment.
The work has helped Katie build a knowledge base in UK equities as well as broader market and macroeconomic events.