Markets remained orderly until late February; movements were consistent with an economic challenge contained to Asia. Safe-haven markets had rallied (the yield on 10-year US Treasuries tightened from 1.88 per cent at the start of the year, to 1.46 per cent on 21 February) while riskier assets, such as emerging market equities, had dropped.
However, the outlook had changed markedly by early March. By then COVID-19 had spread far more widely than many observers had anticipated. It became apparent that unprecedented public health measures, with significant economic implications, were going to be required, leading investors to start repricing assets. March saw risk assets sell-off in a dramatic fashion (with the decline from market peaks even more aggressive than during the 2008-2009 global financial crisis, as shown in Figure 1).
Figure 1: S&P 500 and FTSE 100 in 2020 vs. the global financial crisis
Source: Bloomberg, as at 26 March 2020
Market pricing now implies a high degree of confidence that recession-like conditions will result across most major economies, but uncertainty remains over their depth and duration. Restrictions in Europe and the US are likely to persist for months and will have a major short-term impact on consumer spending and company profits, as well as potential second-order effects from lower incomes. Quantifying this is a speculative exercise at this point, however.
If there is good news, it is that policymakers in government and central banks have recognised the risk of economic damage. Having learnt the lessons of the global financial crisis, they are moving at speed to deploy fiscal and monetary stimulus to support incomes in the real economy and prevent financial markets from seizing up.
Assessing the economic impact
In normal market conditions, fund managers look to construct portfolios able to navigate the range of outcomes that might reasonably be expected. While maintaining exposure to assets that will drive longer-term growth, they typically have three options to manage risk:
- Increase allocations to government bonds;
- Reduce investments in growth-sensitive assets, such as equities or high-yield credit;
- Look for assets in demand when portfolios shrink (including currencies like the US dollar or Japanese yen).
Government bonds, offering a fixed rate of interest, tend to increase in value when economic weakness causes central banks to drive down interest rates on cash. For this reason, we believe they are an important building block in many portfolios. However, we had some concerns about the near-term outlook that prevented us from relying entirely on them for protection. Even before the recent market volatility, investors generally expected central banks to ease rather than tighten policy, meaning that owning as many bonds as possible was a popular strategy. This worsened valuations and raised the risk that any “rush for the exits” could hold bond performance back.
In the event, bonds initially performed their usual risk-off role in late February and early March. US Treasuries, which we tend to favour because of their safe-haven status for investors around the world, performed well and outpaced other markets such as gilts. However, by the second week of March, all bonds began to behave unusually.
Government bonds are normally one of the deepest and most liquid markets, allowing investors to buy and sell large quantities at minimal cost, even in periods of market stress. However, it transpired that many bondholders had borrowed to buy them. As uncertainty increased, they were forced to sell both bonds and equities to raise cash to cover redemptions or margin payments. A wall of bond selling effectively crashed the system like an old laptop, collapsing trading volumes at times to zero and sending prices lower. This meant both defensive and growth assets were moving in the same direction at the same time, exacerbating the fall in portfolio values. Our view was that this forced selling created an opportunity to buy unwanted Treasuries, which have since found support through the actions of the US Federal Reserve. Nevertheless, market moves in March illustrate the need for a multifaceted approach rather than a single source of protection.
It can be tempting to rely on large sales of equities when trouble arises, as a strategy for protecting wealth. However, this is hard to achieve. First, by the time the headlines turn gloomy, a sale is often too late. US equities fell into a bear market (with declines of over 20 per cent) in just 16 trading days – the fastest such decline in living memory. Second, timing a re-entry to growth assets can be a huge challenge. The FTSE 100 gained 16 per cent in just three days to 26 March (see Figure 1).
We prefer to take a more strategic approach and are wary of looking only to equities to drive growth in portfolios. In our uncorrelated allocation, we look for assets that can deliver strong returns but preserve capital in difficult times. This has been an important support in the recent downturn, with assets with such as absolute return strategies seemingly holding their value more effectively than equities.
We also try to manage allocations dynamically, but in a measured way. Before the onset of the virus, our allocation to growth assets was already modest despite evidence the global economy was improving from 2019 levels. Conscious that equity valuations were high by historical standards, we expressed our view only through a small tactical overweight, with a preference for the US, Japan and emerging markets. We felt it was important to reduce exposure to assets with high levels of borrowing such as high-yield bonds.
As markets declined, investors in these more indebted vehicles have found falling prices coinciding with less liquidity. Although equities have declined, we have been able to use the volatile moves in both directions to reduce our exposure to trade-sensitive markets at reasonable prices. Our focus is to be well positioned to put money back to work when our analysis indicates the time is right.
To diversify beyond the conventional equity/bond split, we can invest in currencies that are more resilient to global market disruptions, and reduce exposure to more growth-sensitive currencies.
The US dollar and Japanese yen are traditional safe havens, perhaps because they are often borrowed by companies and investors during good times. When cash flows deteriorate, these borrowers find themselves needing dollars and yen to make repayments. Our own analysis leads us to believe that strategically allowing a degree of unhedged exposure to these currencies may improve the risk-adjusted returns of portfolios.
Running into 2020, the US dollar had been very strong, in large part driven by the US economy’s domestic strength, which insulates it somewhat from global trade and manufacturing woes. In contrast, the Japanese yen had been weak, with markets concerned the Japanese economy might again shrink in 2020, following the 6.3 per cent contraction in GDP in the fourth quarter of 2019. We were less pessimistic than the consensus about the drivers of this weakness, and maintained our exposure.
Balanced against this, the euro and the Australian dollar tend to be more sensitive to global trade and manufacturing conditions. Hedging those currencies can mitigate some of the risks associated with holding growth assets.
During the March sell-off, markets largely conformed to the strategic pattern. The dollar once again strengthened markedly, rising 5 per cent in the first three weeks of March (Source: Bloomberg, as at 25 March 2020) as investors bought it as a safe-haven asset. Yen appreciation, and weakness in euros and Australian dollars, also provided a degree of protection.
How should investors now view diversification in multi-asset portfolios?
March was characterised by exceptional stress in the markets. This was reflected in changes to cross-asset correlations (i.e. equities and bonds declining at the same time) and a drying up of liquidity in many markets. Even well-diversified portfolios have been challenged by these conditions. What recent events have illustrated is that having a multifaceted approach to managing portfolio risk can allow a portfolio manager to navigate volatility, spot opportunities, and strike the right balance between responding to markets and taking a long-term view.
Sunil Krishnan is head of multi-asset funds at Aviva Investors