Fears of the potentially catastrophic impact of the coronavirus pandemic on economic growth brought the 11-year bull market, the longest in history, to tumble at the fastest speed on record. It took only 16 trading days for the S&P 500 to fall more than 20 per cent from the high on February 19, followed by a 34 per cent peak to trough correction on March 23.
With hysterical swings in stockmarket prices, March was the most volatile month for the S&P 500 in history. Nine of the month’s trading days went on record as the biggest one-day gains and losses since the second world war, while high yield spreads surged to post-global financial crisis records.
In hindsight, what could end up being seen by traders as once in a lifetime buying opportunity for risk assets has left wealth managers predominantly cautious. Long-term investing, diversification and capital protection remain key tenets of wealth management, even more so in such unsettling times, while trying to time the market is seen as a big mistake.
With one eye on macro-economics and market developments and another on the progress of virus testing and contact tracing, a cure or vaccine, economists and chief investment officers are drawing up market scenarios, looking ahead to a post-crisis environment, when winners and losers will have emerged, and are studying which long-term investment trends the pandemic may have accelerated.
At the beginning of March, once it became clear that the epidemic would not be contained to China and that the rapid spread of the virus in Italy would lead to an escalation of new infections across Europe and the US, at Société Générale Private Banking derisked portfolios across the board, cutting exposure to equities and bonds, as long dated fixed income yielding negative interest rates were offering little value and diversification.
“We raised cash to have dry powder to use, once opportunities arise,” explains Alan Mudie, global head of investment strategy and CIO at Société Générale Private Banking.
In what is expected to be a continued period of high volatility, preserving capital is a top priority, allowing reinvestment from a position of relative strength with “sizeable” cash balances. Periodic relief rallies are typical of bear markets, he warns.
In the run up to Easter, the climb of US stocks by 25 per cent from their mid-March low has technically lifted stockmarkets back into a new bull market, but one fraught with extreme uncertainty over the outlook for companies and the global economy.
Economists’ consensus and the current pricing of the equity and high-yield markets anticipate an extremely sharp recession in the first and second quarter, with a gradual recovery starting in the third quarter, following staggered lifting of containment measures by summer. While the IMF has warned the world is facing the worst economic crisis since the Great Depression of the 1930s, the full extent of the economic contraction will depend on the duration of lockdown policies, which are currently enforced on nearly half of the world’s population.
Central banks and governments are rolling out a wave of unprecedentedly large fiscal and monetary policy packages to shore up their economies. But key questions remain on how effective these policies will be in limiting corporate bankruptcies and job losses in the short term and protect against long-term economic damage.
More big market falls and volatility spikes may be on the horizon. So when is the right time to get back into markets? The market turn will be sharp, as soon as it will be able to anticipate improvements in business conditions, says Mr Mudie. But measures such as investor sentiment indicate that investors have not yet “thrown the towel in”, which tends to be the signal that the market has found the bottom.
Long-term perspective
The healthcare crisis supports the bank’s focus on quality businesses, with clean balance sheets, clear objectives set for their long-term strategy and sustainable business models. These firms typically score well in ESG criteria, as they tend to be less leveraged than the average, have better relationships with the workforce and enjoy higher employee satisfaction. They also tend to be more attentive to the environmental risks that their activity entails, and have measures in place to mitigate that. These businesses are also the ones that tend to surge during recessions, because of the robustness built in their business models, adds Mr Mudie.
Strategic investment themes such as healthtech have become even more relevant. Healthcare globally contributes about 10 per cent to GDP, but only represents 5 per cent of data held in databases. Thanks to big data and AI technology, companies and governments will be able to capture and stock large quantities of data and unlock the value within that massive unstructured data set. This has clear implications for healthcare, from pharmaceutical and biotech sectors right through to the way practitioners can advise and diagnose ailments in their patients.
As an investment theme, cybersecurity is also gaining increasing traction today. “Working from home poses a whole new set of problems in terms of security of data and is an area of continuous, high levels of investments,” adds Mr Mudie.
Although this crisis is unprecedented, investors should keep a long-term perspective, says Yves Bonzon, global CIO, Bank Julius Baer. The strategic asset allocation should be investors’ “anchor” and reviewed only once or twice annually. “We tend to overestimate short-term change and underestimate long-term trends,” he says. While the temptation to reduce risk and limit the drawdown in the short term is extremely high, investors are rewarded for accepting short-term risks for superior long-term returns. However, he also warns investors against jumping into markets, attracted by the high value risk premium of quality assets, if compared to lower quality assets, both in the equity and fixed income space. This is premature, he says, as there will be several ups and downs before the economy recovers. Also, the economy is “hostage” to policy decisions, with government intervention in markets and economies expected to be very high. “We cannot apply the usual mean reversion logic to value situations. Don’t catch falling knives,” he warns.
Among many trends, the healthcare crisis is accelerating the trend towards a bipolar world, led by China and the US, says Mr Bonzon. China was the first to be hit by the pandemic and reacted very swiftly, and will also be the first economy to recover. This drives Pictet to continue to view China as a core asset class in client portfolios.
With its careful application of right public health measures, China has proven that an economy can certainly bounce back, drawing a ‘V’ shaped recovery, states Stéphane Monier, CIO at Lombard Odier. However, the Chinese economy, while certainly less export dependent than a dozen years ago, remains highly dependent on consumption in the rest of the world, where markets are more or less frozen. At this stage, the most likely economic recovery curve, at global level, looks something closer to a tick, a brutal decline followed by a quick rebound that then tails off, says Mr Monier.
During such a volatile period, it is important to maintain a diversified and liquid portfolio. “We have consistently adjusted our equity exposures across portfolios to take account for the market drift they experience in such a volatile environment and sold positions in emerging market debt in hard currency, holding the cash for now in reserve.”
Until the effectiveness of US public health measures is clearer, Mr Monier sees limited equity market upside from current levels. “The market rebound may reverse as negative news on economic data, profit warnings and credit rating downgrades hits. We have therefore bought some portfolio protections in the form of put spreads,” he explains, adding that liquidity in the bond market remains difficult with limited opportunities to buy good issues. To limit volatility, portfolios also include hedges such as gold, the yen and the Swiss franc. Alternatives including real estate, infrastructure and hedge funds, are also an increasing proportion of assets in portfolios.
Rebalancing
Gradually rebalancing client portfolios back to their target equity allocation is crucial in market falls.
“Drops in stockmarkets should be used to rebalance portfolios back to their target equity allocation, using an averaging in strategy to build up positions over weeks and months, so that clients are not under exposed when they get to the recovery stage and that portfolios are appropriately positioned for when the recovery can take hold,” says Dean Turner, economist, UBS Global Wealth Management.
Also, clients should be looking to use option strategies to gain exposure to the upside, and also to secular themes that can benefit from the current crisis. These include fintech, e-commerce, online gambling and online education, as well as cyclical sectors, which look oversold, in particular Chinese property and some automation stocks, which offer good long-term opportunities.
The “speed and nature of the market adjustment” recently drove Citi Private Bank to recommend to clients they buy equities, if they are under-represented in balanced portfolios, using a very disciplined approach, and rebalance portfolios to their target allocation. A meaningful majority of the bank’s UHNW clients have been overweight cash and underweight equities for the past 10 years, and were looking for an opportunity to buy, explains Steven Wieting, chief investment strategist and chief economist at Citi Private Bank.
However, despite the severe drop in March, Citi Private Bank has not raised its allocation to equities yet, since reducing it to neutral, as the virus started spreading rapidly in Europe in late February.
“Equity and credit markets have fallen hard, but have not clearly overshot,” says Mr Wieting, explaining the decline in share prices is not as large as other, more severe systematic level economic collapses, like the one in 2009.
Ignoring asset allocation and trying to time the market is a “big mistake”, adds Mr Wieting. Over the last two decades, if an investor missed the two single best days of each year, US equity returns would fall from around 7 per cent to minus 3 per cent. But being fully invested during the market’s worst days has a similar effect. For the risk averse, a balanced portfolio of equities and high quality bonds, such as US Treasuries, and alternatives can smooth out the ups and downs.
Winners and losers
The drop in global equities has been distributed “reasonably rationally” between winners and losers, which is a reason for not cutting allocation to equity further, explains Mr Wieting. A period of “tremendous dispersion” in performance lies ahead. Despite very strong and fair policy response, small businesses will be hit hard. Industries such as healthcare, some consumer staples, much e-commerce, and digital media will see little or no disruption from Covid-19, and indeed are likely to generate higher revenues and profits this year.
Other sectors, such as energy, hospitality, airlines, and consumer discretionary, will bear the brunt of the immediate collapse. “It is also important to focus on balance sheet strength, as the most cash rich firms with the highest margins can survive a temporary absence of revenue. Many others must get outside aid or perish,” says Mr Wieting, who remains pretty upbeat. “Humanity has never faced a virus it hasn’t beaten. Looking beyond the depths of the present crisis, it is not difficult to be optimistic on the outlook for future years.”
Deutsche Bank believes the time to add risk gradually in portfolios may have come already. If lockdowns are not extended significantly and are gradually loosened, the effects of monetary and fiscal stimulus will start to yield results. This will drive a strong initial economic recovery followed by a more muted growth.
Markets typically turn before the economy picks up, and these turns can be sudden, with the risk of subsequent temporary setbacks. “Markets are going to remain unpredictable in the short term and adding risks on a staggered basis in a disciplined way should help mitigate risks around market timing,” says Markus Müller, global head of chief investment office at Deutsche Bank Wealth Management. Otherwise, investors who try to perfectly time the market may miss the point of trend reversal.
While the economic recession is going to be very severe, it is important to focus on what the world could look like in six to 12 months’ time, says Mr Müller. The likelihood of a “lower yields for longer” environment, supported by low inflation, adds to the longer-term case for equities. “Equities are the most attractive asset class, especially stocks with a solid business model, and companies active in sectors which are resilient to such a recession, such as essential goods and services, healthcare and IT.”
Investors should focus on low leverage stocks, which can be “masters of their own destiny”, states César Pérez Ruiz, head of investments and CIO at Pictet Wealth Management, explaining the bank has still an underweight exposure to equities. Clients should look forward to long-term winners, focusing on themes such as biotech, healthcare, internet-related sectors, which also support working from home strategies, including data centres. Infrastructure is another big theme, as governments increase their investments.
Volatility mitigation from portfolio diversification is one of the “few free lunches” for investors. Central banks’ accommodative monetary policy has kept volatility artificially too low for long time, which means it is crucial that clients’ risk profiles are correctly reflected in portfolios, so that they can “stomach” downturns. “The most important thing is that clients remain invested and not panic at the wrong time,” says Mr Perez.
However, before adding risk in client portfolios, he wants to see “capitulation” of the equity market, “a wash out with people giving up on equities”, and revision down of forward earnings forecasts by 20-30 per cent. More importantly, countries like Italy, Spain and the US, which have been hit the hardest by the outbreak, need to be able to indicate a lockdown exit roadmap, which would allow the quantification of the depth and length of the slowdown.
Prolonged recession
The base case of a very deep but short-lived recession is largely priced into markets, says Eli Lee, head of investment strategy at Bank of Singapore. Analysis of market data over the last seven decades shows that US recessions lasting for less than a year tend to result in an average S&P 500 correction of 20 per cent, with a range between 13 per cent to 37 per cent. This is generally in line with the trading range of the equity correction during this crisis so far.
But this base case scenario can only happen if, in addition to the peaking of the infection rates ahead, the risk of second and subsequent waves of infections are being successfully managed by policy-makers, warns Mr Lee. Various surveys show that subsequent infection waves are not at the top of lists of investor concerns, although medical experts caution that resurgence of infections are likely to happen. The World Health Organization has recently warned that resurgent infections could lead to an economically destructive cycle of repeated lockdowns if restrictions are lifted too soon, and there are already warning signs of this in China, Japan and Singapore.
Although there are grounds to hope that increased testing, greater awareness and more experience would help curtail the harm from subsequent waves of infection, this downside risk needs to be monitored carefully, says Mr Lee.
“An increase in the risk of a prolonged recession would have severe market implications, and we could see markets testing and breaking below their recent March lows,” explains Mr Lee. History shows that prolonged recessions lasting more than a year tend to lead to a far sharper average equity correction of 38 per cent with a range between 21 per cent to 57 per cent.
This volatile environment calls for careful capital management and a long-term mindset. “It is critical to focus on high quality assets with resilient balance sheets and growth, as many companies will be permanently impaired by the sharp recessionary shock, and some will not survive,” he adds.
