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Inflation and economic data are screaming at investors to run for the hills. But what if the hills are hard to find?

Asset markets are cratering, risk appetite is evaporating, and volatility is spiking as the highest price rises in 40 years push up market-based borrowing costs and expected policy rates.

If inflation were the only challenge, investors’ options to hedge or diversify their portfolios might be more straightforward. But growth is fragile, and the probability of recession in the next 12-18 months is rising by the day.

The University of Michigan’s consumer sentiment index plunged to the lowest last week since the index was launched in the 1970s. The recession bells could not be ringing louder.

A big problem with this storm is the fact that no one in financial markets under the age of around 60 will have any experience of “stagflation.” Most investors are flying blind.

Crucially, the old safe-haven plays investors would typically load up on are no longer options - bonds are getting crushed, the Japanese yen has plunged to its lowest since 1998, and dollar cash burns a 7% real hole in your pocket.

“It’s going to be a challenge until the market feels the end of Fed tightening is visible. And it’s safe to say the end is not in sight,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “We are in a difficult spot.”

WALL STREET DOWNSIDE

That may be an understatement. The blunt truth is the re-pricing of the Fed’s interest rate outlook this year has been so extraordinary that virtually no asset class and financial market would emerge unscathed.

U.S. rates futures markets now expect the Fed’s policy rate to peak at just under 4% around the middle next year. Barely two weeks ago, the expected “terminal rate” was below 3%.

Unsurprisingly, the typical portfolio weighted 60% to equities and 40% to bonds is having a terrible year.

According to analysts at Truist, a typical 60-40 U.S. portfolio was down 15% this year as of last Friday. Looking at data going back to 1926, that would be the fourth worst year on record, they say.

Depending on the construction and leverage, some equity-bond portfolios are nursing significantly greater losses this year.

The S&P 500 is down 20% so far this year and flirting with bear market territory. Larry Adam, CIO, Private Client Group, at Raymond James, reckons the index could fall to 3400 - another 10% to the downside - before long-term investors see a “compelling opportunity.”

Analysts at Citi warn that corporate earnings forecasts have further to fall, which could push Wall Street down a further 10%-15%.

Their analysis of the past 90 years shows that the S&P 500′s median “pre-recession” drawdown is 23.6%, and the median recession pullback is 28.4%. If the economy does fall into recession, expect further “meaningful downside” for stocks.

BONDS BATTERED

Investors would previously have offset such losses by buying bonds, but not this time.

The Bank of America Treasuries index is down more than 10% this year and the U.S. corporate bond index is down 14%, both well on course for their worst years in at least quarter of a century. The junk grade corporate bond index is down 10%, on for its biggest annual loss since 2008.

So where should investors run for cover?

Citi’s analysts suggest buying gold, and investment grade corporate bonds over “junk”-rated paper, while the energy sector is “interesting” too. Within equities, defensive sectors - especially healthcare - tend to outperform in recessions, they say.

Gold has mostly held its ground so far this year thanks to a 9% surge in the two weeks after Russia invaded Ukraine in February. But it has since entirely retraced that move and has struggled to rise in the face of rampant inflation.

Bitcoin? The carnage in cryptocurrencies - bitcoin has lost half of its value this year, and is down 12% on Monday alone - is surely proof that these investments are not the inflation hedge or diversification their proponents claim them to be.

For Yung-Yu Ma at BMO Wealth Management, real estate offers “decent” diversification, while investors should consider a basket of commodities including energy, mining, precious metals, and agriculture as part of a broader portfolio.

“(But) the best case scenario is not one where markets go gangbusters and resume their climb into the end of the year. It’s more likely to be a slow, steady grind back up, and some relief from inflation,” he said.

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