Multi-asset positioning for extreme uncertainty
3 June 2020
Appreciation of the risks in the market at the moment and having an eye on the checks and balances being employed are essential, says Wayne Nutland, head of Managed Index Solutions, Premier Miton Investors
The coronavirus crisis has delivered a profound shock to society, the economy and asset markets, leading to many deaths and illnesses, and job losses and other economic worries for many more.
In the markets, whilst the size of the moves in many asset classes was within historical precedent the speed of the moves was in many cases highly unusual. In the space of a few weeks’ equity markets moved from all-time highs to bear market and investment grade credit spreads rose some 350 basis points. The speed of the moves of course reflecting the ‘sudden-stop’ impact of the lock-downs, as opposed to traditional cyclical declines which take longer to unfold (and to measure). Whilst risk assets sold-off, government bonds of ‘safe haven’ nations appreciated, reflecting cuts in base rates and markets adjusting lower their expectations for longer term rates and inflation.
However since late March, a sharp recovery has taken place in equity markets, with the S&P 500 recovering about two thirds of its losses from the February peak. With the major economies facing a severe recession, it seems hard to believe that US equities are down just 6% since the start of the year, and to a sterling investor are actually slightly positive as the US dollar has appreciated against sterling.
What’s going on?
The extent of the rally has surprised many investors (this one included). Of course it’s easy to rationalise market movements after the event but doing so is vitally important to help assess what markets are currently pricing.
The rally isn’t perhaps as reflective of a ‘V-shaped’ economic rebound which it could be taken to be at first sight. The rally has been led by technology and associated companies, which are well placed to benefit from accelerations in digital adoption, whilst lower interest rates and bond yields support the valuations of higher growth sectors, where more value is priced into the future.
This leadership as well as the general dynamism of the US economy has enabled US stocks to continue their multi-year outperformance of other equity markets. The more cyclical sectors and markets have been far less strong, although in recent days there have been some signs that the parts of the market which have lagged the rally are beginning to see improved performance relative to the Tech leaders.
It seems certain that policy developments have been critical to the rally seen in equity markets – falls in interest rates, QE, unprecedented central bank involvement in financial markets, stimulus and support measures such as the furlough scheme. There have been some positive developments towards developing medical solutions to the crisis, but there remains significant uncertainty over when, or indeed if, these will ultimately prove successful. Overall, these developments combined with the gradual (and so far broadly on track) measures to re-open economies, have enabled equity markets to rally.
Interestingly the extent of the recovery in equity markets hasn’t been matched in its extent by signals from other asset markets – bond yields remain low (although are of course heavily influenced by central bank involvement) as do commodity prices, whilst gold and credit spreads remain elevated (although credit spreads have recovered from the highs).
Although economic activity is beginning to recover from the lockdown lows, activity remains severely depressed, unemployment high and there remains the ongoing risks of second wave of infections and secondary lockdowns, which although they could be easier to prepare for logistically, ongoing periodic lockdowns could do more long lasting damage to companies and sentiment.
How to position?
How does an investor position against such an uncertain backdrop? Economic forecasts are of little use given the wide spread of forecasts, similarly corporate earnings expectations are also highly uncertain, indeed many companies have stopped providing guidance.
It’s an old cliché but diversification is particularly important at times of elevated uncertainty. Although government bond yields and likely future returns are very low, government bonds remain tactically useful in a portfolio context to at least offer some buffer against future equity market falls even if the scope for further price appreciation is limited given such low starting yields. Although even here, the possibility of the Fed and Bank of England moving to negative rates has increased. US Treasuries have proven once again to be the global safe haven asset, whilst currency hedging costs have come down significantly for non-US investors. However whilst government bonds continue to have an important tactical role to play in the near term, longer term returns look challenging, suggesting lower long-term weightings when visibility has improved.
Credit looks better placed than government bonds, critically the support from central banks may prevent credit spreads fully pricing in the extent of the economic damage being seen. However, even here, although spreads are attractive historically which should deliver better returns than government bonds, total yields are not particularly high given the low level of government bond yields.
The position for equities is more mixed. Following the rally equity market valuations are now stretched on an earnings basis, although there is significant uncertainty over the near-term level of earnings and how quickly they will bounce back. Relative to bonds equity valuations continue to appear attractive, although this, of course, is an indication of potential relative returns rather than potential absolute returns; after a brief absence TINA (there is no alternative) has arrived back on the scene.
Balancing the risks
The gradual re-opening of economies, potential for a vaccine and high equity risk premia relative to bonds needs to be balanced against the severe economic recession, high earnings based valuations (and uncertainty over earnings) and the risks of a resurgence of the disease, arguing for balanced exposures overall. Furthermore, the extent of the equity market rally perhaps suggests that future movements could be asymmetric on the downside should a negative scenario emerge.
Within equity markets secular growth themes continue to look well placed, providing a mix of some cyclical exposure as well as characteristics which have proved somewhat defensive given the nature of the crisis.
Having said that, if economies continue to open without significant further spikes in virus cases, tactically adding to more cyclical areas opportunistically may make sense given the extent of underperformance over recent years.
It’s probably worth adding some inflation protection. Although the crisis is proving to be deflationary in the near term there are strong arguments for an inflationary response in the future.
The period after the financial crisis proved that expansion of the monetary base is not inflationary in itself, although there are several factors which are different this time. Governments are starting from higher levels of debt, and perhaps more importantly are launching significant stimulus measures as opposed to austerity programs.
Given the expansion in government debt, central banks will be required to help to ensure that interest rates don’t make the cost of debt servicing prohibitive, perhaps with more central banks adopting yield curve control policies, which would prevent government bond yields embedding an inflation premium.
Furthermore, de-globalisation as a result of ongoing China US tensions, as well as a post-crisis desire to boost supply chain resilience may be inflationary, or at least would remove a deflationary impulse. Inflation linked bonds are likely to deliver better real returns than conventional bonds, once the initial deflationary shock has passed.
Also on the inflation theme, gold deserves a place in portfolios, although following a strong performance in recent months may not deliver in the near term without the support from further falls in real rates. Commodities may be attractive given low oil prices, however recent events in the oil market have severed as a reminder that commodity investment is usually via futures rather than the commodities themselves, and roll yields remain a drag on returns.
Finally, low real rates imply that returns across the asset class spectrum are likely to be lower going forward, stressing the importance of keeping costs low.
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