Interest rates

Investing in Inflation, Interest Rates and Deflation Strategy: Nancy Davis

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  • Nancy Davis of Quadratic Capital Management tells investors to watch out for credit risk.
  • She says investors often fail to diversify because their stocks and bonds carry the same risks.
  • His company recently launched an ETF aimed at profiting from deflation that attracted $200 million.

Fundamental financial advice is “know what you own”. This means that it is essential to understand the companies in which you have invested – and the risks these companies face, even if they are not obvious.

Nancy Davis, chief investment officer at Quadratic Capital Management, says many investors miss some important risks lurking in their portfolios, even when they’re diversified across stocks, bonds and other assets.

Davis, a former head of credit derivatives and OTC trading for Goldman Sachs, made a name for herself and her company with a unique approach to inflation and interest rates — not to mention some correct predictions. market crashes in 2018.

Right now, she’s warning against a basic approach to diversification that investors have been using for years. Given that government bonds have generated historically low yields in recent years, many investors have poured their money into a host of slightly higher-yielding alternatives like corporate bonds, bank debt or loans. leverage.

But Davis says that for all their differences, these types of investments are all exposed to credit risk and exposure to weaker corporate performance, which would also hurt equities. This means that under the wrong conditions, investors could experience losses in both parts of their portfolios at once.

“In general, investors have a lot of correlation risk inside a portfolio. If you have stocks and corporate bonds, the same companies that issue their debt, you kind of have the same beta“, she said. “If we have an environment where costs are increasing, whether it’s input costs or labor costs, personnel costs or shipping costs , either way, it can lead to lower earnings per share growth, which is generally bad for businesses.”

And higher costs are now a top concern for investors. Over the past two months, inflation has reached its highest level in 40 years, adding to the pressure on the


Federal Reserve

to raise interest rates, which would slow the economy and reduce inflation over time. The Fed has indicated that it will begin a series of rate hikes next week.

In addition to inflationary pressures such as supply chain disruptions and pent-up demand from buyers, Oil prices have skyrocketed since Russia invaded Ukraine last month, and now the United States should ban imports of Russian oil, gas and coal. US crude prices are up 55% in 2022.

This only makes these concerns about economic growth, business costs and inflation all the more acute.

So the concern is that rising costs will hurt equities, increase the risk of default when bondholders aren’t repaid, and also cause corporate bonds to decline in value. The whole point of diversification between stocks and bonds or other assets is to have assets that won’t all fall at the same time, and Davis argues that investors should be aware that even well-diversified portfolios can be vulnerable. to that.

Davis’ business is focused on creating investment vehicles for today’s market, and that’s part of the terrain for his company’s ETFs, because Davis says they’re not dependent on the performance of company or that they are not correlated to it.

“I think it’s just the right time for investors to add long fixed income


volatility

to their wallet,” she said. “Especially if we have higher prices, lower growth, that’s the stagflationary outcome. And that’s really, really, generally bad for 60-40 year olds especially where stocks and bonds sell together.”

For decades, investors have been told to put 60% of their assets in stocks and 40% in bonds; the approach was seen as a rule of thumb for sound investing. But ultra-low bond yields have prompted many pundits to say this approach is dead, and investors have been looking for alternatives that will offer better returns.

Quadratic’s nearly three-year-old Interest Rate and Inflation Volatility Hedging (IVOL) ETF is designed to profit when the yield curve steepens while protecting investors against the risk of rising inflation expectations and rising interest rate volatility.

And in September, Quadratic launched a deflation ETF (BNDD), which attracted nearly $200 million in investment. It buys treasury bills and over-the-counter option trades to profit from potential deflation.

“It’s nominal and not inflation-protected,” Davis told Insider. This means that it is designed to perform better when the Federal Reserve makes a policy mistake or when long-term Treasury yields fall due to factors such as a weakening economy.

While Davis’ funds are unique in their design, they are far from the only ways for investors to gain exposure to some of the themes she addresses. For example, there are ETFs that invest in inflation-protected Treasury securities like this iShares fund which are designed to provide stable returns while being indexed to inflation so that investors do not lose money when inflation rises.

Investors concerned about inflation can also buy gold or commodities like oil which tend to do well when inflation rises. They can do this by buying shares of companies that mine gold or sell commodities, or by buying industry-related ETFs such as the iShares Gold Trust or the iShares US Oil & Gas Production & Exploration ETF.