In the current financial landscape, marked by es­calating and widespread systemic risks, efficient and effective risk management has become paramount. As global markets grapple with uncertainties ranging from geopolitical tensions to economic instability, in­vestors face mounting challenges in safeguarding their assets and achieving sustainable returns.

Cloudy outlook

A confluence of factors spanning economic, geopolitical, and societal domains has contributed to a landscape characterized by modest (at best) growth prospects and intensely heightened volatility.

One of the foremost concerns is the proliferation of high debt levels across both public and private sectors. Years of accommodative monetary policies, characterized by low interest rates and quantitative easing, have fueled a debt binge, leaving economies vulnerable to shocks. Moreover, the surge in money supply and the resulting inflationary pressures, present a real challenge to investors and savers alike.

Central banks, which either officially or unofficially have the dual mandate of promoting economic growth and curbing inflation, find themselves cornered. A premature return to QE and lower rates could lead to a second, potentially more severe and prolonged inflationary wave, while the “higher for longer” approach of key central banks like the Fed risks triggering a dangerous economic slowdown or even a full-blown recession.

In fact, a wider slowdown is already a concern for many investors, with the trajectory of China being especially worrying. The world’s second-largest economy, once a primary engine of global growth, is showing signs of deceleration that are becoming increasingly evident, with potential ripple effects.

Geopolitical tensions could negatively impact global supply chains, causing disruptions similar to the covid crisis. Further heightened volatility in oil and gas markets adds another layer of uncertainty to the economic landscape. This sector must also grapple with the mounting pressure to transition towards a “green economy”, with increasing environmental regulations and government interventions.

Finally, from a big picture point of view, we must also factor in long-term trends like demographic shifts. Aging populations and declining birth rates in many advanced economies pose long-term challenges to growth, labor markets, and social welfare systems. At the same time, the pandemic “legacy” effects have introduced a “new normal” that is set to compound these pressures, with the rise of remote work, of social division and with the increase in governmental interference in managing the economy and in private life.

Investment Implications

We assume that the financial markets will be stagflationary in the coming years, exhibiting significantly higher volatility and fluctuating within a wide range without a clear trend. We agree with legendary investor Stanley Druckenmiller, who warned of a “high probability” of the stock market remaining “flat” for an entire decade.

With this mind, and given the multitude of risks that lie ahead, it is clear that a buy-and-hold strategy will not work in the coming years. Instead, we prefer to focus on specific sectors and themes that we expect to have a low long-term correlation with the broad market, while avoiding other sectors altogether, thus accepting greater deviations from a benchmark.

Uncertain times like these highlight the need for proper and thorough risk management. However, we have found that this concept is frequently misunderstood. Many investors focus on downside protection (if at all), through put options only, without considering the wider context and the actual composition of their portfolios. They fail to recognize that portfolio risk management is a much more holistic concept and that it should encompass and guide their entire investment strategy, instead of being a mere afterthought or a “bandaid” solution after the fact.

Meaningful risk management begins by constructing a resilient portfolio that can withstand the above-mentioned pressures and risks, while still benefitting from the opportunities that lie ahead. This starts with a forward-looking asset class allocation strategy and continues with a careful selection process within the asset classes. With equities, for example, the selection of sectors and themes is crucial. Which of these will perform well even in a stagflationary environment? Which will not only offer protection, but also provide good growth opportunities? This is our approach at BFI Infinity, the core tenets of which we’ll outline below.

While we generally consider stock markets, especially in the US, as being largely overvalued, this doesn’t mean that investors should shun stocks altogether. There are still sectors and themes with solid companies out there that can make valuable contributions to any portfolio if one knows how to look for them. As mentioned above, we place great importance on specific themes and that’s where we concentrate in our search for healthy and promising in-vestments. For example, our focus is on commodities (e.g. copper), energy (e.g. uranium and oil services), defense, and to some extent technology (e.g. semiconductor equipment), among other sectors, as the current and future economic and geopolitical dynamics seem favorable.

When it comes to bonds, the higher interest rate environment of the last two years has delivered some significant returns for this asset class. With this in mind, we have revised our previous strategy and decided to cautiously and selectively include bonds, although we still remain underweight. We focus mostly on high-quality short- and mid term bonds. Currency denomination is important of course, which brings us to our currency outlook.

We still see the CHF as the most stable and reliable currency compared to most of its peers, including the USD, despite the Swiss National Bank’s efforts to limit its strength. Having said that, the long-term outlook for all fiat currencies remains negative due to the general mismanagement of central banks and governments. Measured against gold, most, if not all, will lose value.

This is why are overweight on physical precious metals, as well as their respective miners. It is by now abundantly clear that gold has benefited massively from the inflation wave that resulted from the excessive “print and spend” policies of the last few years, and we expect the yellow metal to continue its long-term upward trajectory. Central bank buying (especially from the BRICS alliance), but also institutional and even retail demand are likely to support higher price levels. The outlook for silver should be even brighter, as it enjoys significant industrial demand, fueled by the wave of electrification and alternative energy, on top of its investment demand. It is important to note however that silver tends to be more volatile and its downside potential needs to be taken into consideration in allocation decisions.

We are also bullish on other commodities as well, as many are poised to perform well due to over a decade of underinvestment. As a result, the supply of some commodities will fall while demand remains constant or climbs higher. Even in the event of a recession, it could still be the case for some commodities’ supply to fall more sharply than demand, causing the price to rise. Uranium is a great example, a topic we examined in our last InSights report. Copper is also bound to keep enjoying high demand, especially stemming from developing economies. The same can be said for coal, which said economies will realistically still need for years to come in order to grow further, but which has suffered a steep drop in investment flows due to the “green revolution”.

It is also important for investors to consider alternative investments. We found that hedge funds in particular are more essential than ever, given the overall uncertainty in the markets and the economy at large. For years, we have relied on a mix of largely defensive hedge funds that have a low correlation with the stock market (they more or less served as a substitute for bond positions that we held in the past). Not only have they proved to be very reliable stabilizers during strong corrections, but they have also generated attractive returns. Of course, diversification through the selection of different strategies is crucial, and it goes without saying that we regularly reassess our allocation and adjust it if necessary. For the time being, we see a mix of hedge funds as an important component of risk management in a robust portfolio.

When it comes to other alternative investments, we also hold a small position in digital assets. Rather than picking specific cryptocurrencies, we are invested in the AltAlpha Digital fund, a BFI affiliated fund, which covers the crypto sector as a whole, as we are optimistic about the future of blockchain technology itself and its many applications.

Finally, with regard to what is traditionally understood as ”risk management”, namely the use of put options for hedging purposes, we partially hedge our equity exposure in our standard strategies against the broad market indices when we believe this is appropriate. Our focus here is on protection against significant market corrections. Paying an ”insurance premium” enables us to remain invested and still effectively exploit potential upside returns. As we have already explained, we do not consider put options to be our primary defense or the core of our risk management strategy; they are merely one of the available tools.

In summary, it is important for investors to understand that portfolio risk management is a comprehensive approach that must include many different considerations, factors and tactics in order to successfully navigate the muddy waters that lie ahead.

To access the full report and read more about the second article in it, which is all about gold's role in the current financial market, click here.

‍