As the volatile and stressful year of 2011 draws to a close, it is time to take stock of our portfolios and consider some of the risks embedded in them. Below are a few situations we should consider as possible (or probable). How would various assets in your portfolio perform in each situation? And what changes should you make based on the likelihood of these events happening?
The U.S. fiscal situation deteriorates
As the U.S. government issues more debt to finance current spending, inflation could rear its head and bond vigilantes could punish the U.S. for playing with a dangerous debt-to-GDP ratio. Potential outcomes of such a situation would be the unravelling of more than 20 years of negative correlation between bond and stock performance. Every time equity markets decline, bond prices rise (yields decline) and vice versa (although in the context of a broader 30-year bull market in bonds). A change in this relationship could prompt income-yielding stocks to underperform the broad market as equities fall. We would expect equities to fall since higher bond yields would likely result in lower growth as financing costs increase for all entities. A further result would be the weakening of the U.S. dollar against its trade partners.
Gold stops trading as a currency
Gold has traded as a de facto currency for the past year, allowing it to appreciate while the European sovereign crisis flared. If gold trades as a commodity rather than a currency, it will depreciate when global growth appears to slow and leveraged long positions will be forced to liquidate. Portfolio risk should consider this possibility.
Breakup of the euro
The euro has endured significant stress in 2011. Unless measures are enacted to ensure that all members adhere to their promised fiscal restraint, the euro is probably headed for failure. A breakup of the eurozone will likely result in underperformance of the successor currencies against the U.S. and yen, contraction of equity prices and increased price volatility for companies with operations in the eurozone.
Slowdown in China
It is already being observed that nosebleed levels of growth in the teens are dropping quickly to mild single-digit growth levels. Loan reserve ratios are being cut to spur lending. But it may be baked in the cake—slower growth for China translates into slower world growth and certainly further slack in commodity prices. The wild card remains the impact on the currency and bond markets, though I believe any slowing in China will slow the rise in the yuan and create further demand for U.S. bonds as the peg is reinforced. Expect Canadian equities to underperform due to the concentration of commodity-sensitive stocks.
Canadian housing
With residential real estate at new highs, what would be the impact of a 20% drop? It appears the consumer would slow the insatiable demand for further credit, but the structure of our mortgage market seems to give the banks immunity from such a drop. First of all, the Canada Mortgage and Housing Corporation (CMHC) or the homeowner (if equity is high enough) will absorb the initial hit, assuming prices drop less than 25%. Second, I have been assured that laws in Canada require an individual to declare bankruptcy in order to walk away from an upside-down mortgage (when the mortgage value exceeds the value of the home), in contrast to what we have seen transpire south of the border. In such a situation, expect a lower Canadian dollar, lower equities and lower bond yields in Canada. A required bailout of the CMHC in such a situation would dampen the relative value of Canadian long bonds versus those in the U.S.
It is generally difficult to predict the future; however, as risk managers, we must always remain acutely aware of what may lie around the corner and how our portfolios will react. Other situations to consider include further fiscal stimulus in the U.S., appreciation of local currency versus trade partners forcing nations (including Canada) to intervene by selling their own currency, and continued drops in bond yields forcing pension funds to hedge interest rate risk.