After concluding that common stocks needed to play a role in my portfolio, I began hunting for ways to mitigate the risk of holding them.
Our last crisis revealed how exposed many investors were to deflationary risks. In a time of paper money, many investors dismissed the risk of deflation. As it turns out, a severe credit contraction puts downward pressure on almost all asset classes. Credit is the oil that keeps the global economy’s engine running, and without liquidity the engine seized up entirely.
Real estate, stocks, commodities, corporate bonds, and mortgages all went down in value. Even less mainstream asset classes such as gold and fine wine declined in value during the 2008 crescendo sell off. Many investors cried that we had seen the death of diversification! Where were we supposed to run?
United States Treasury bonds were the last house left standing. In fact, Treasury bonds with long maturities of 20+ years shot through the roof in value. This occurred because US government bonds are the safest instruments to store wealth in when the economy faces deflation. One measures how safe a bond is by how easily the debtor can make their interest payments. The US government borrows money in its own currency, so you can be certain they will make their payments. They have the power to create new currency, ensuring that they will be able to pay their nominal debt obligations. During a deflationary crisis, any investment that can make good on its nominal obligations without risk is fantastic.
During the financial panic, investors around the world fled to US government bonds. The chart below shows an index of 20-30 year government bonds, contrasted against the stock market represented by the S&P 500. The green line represents the government bonds and the blue line represents the stock market.
As you can see, when there are deflationary risks the two lines often move in opposite directions.
By combining the two assets one can reduce a portfolio’s volatility considerably. In the chart below, the green line represents a portfolio with half of its capital in 20-30 year treasury bonds, and the other half in stocks. The blue line represents strictly the stock market.
Adding 20-30 year Treasury bonds to the portfolio reduced volatility, creating a smoother ride for investors. A portfolio with long term Treasury bonds can gracefully survive a deflationary panic.
Treasury bonds worked exceptionally well in our recent panic because it was a deflationary crisis. The portfolio would have been decimated if our crisis were inflationary in nature. When we buy a government bond, we can be certain we will receive the nominal amount of dollars promised, but we cannot be certain how much the dollars will be worth. Inflation is the sole enemy of a government bondholder. The longer the maturity of the bond, the more sensitive it is to changes in inflation/deflation. A 30-year bond is likely to be one of the best asset classes to own in a deflationary environment, but it is also likely to be one of the worst in an inflationary environment.
Inflation has not been a significant threat for almost 30 years and government bonds have performed very well through out this period, but inflation is still a threat worth protecting against.