Economic shock exposes vulnerable valuations
The continued spread of COVID-19 across the world has administered a shock to the global economy, with material impacts already felt on both the supply and demand side. Yet while central banks and governments appear ready to take further measures, it is not yet clear whether they will be enough to counteract market headwinds.
In our recent market outlook, we argued that 2020 would be very different to 2019. This reflected a starting point of extended valuations which placed a significant onus on companies, economies and policy makers to deliver. We argued that there was little room for error, that investors generally were far too complacent, and that if a recession unfolded (for whatever reason), central bank action may not be enough to prevent a material re-pricing of risk.
Recessions and bear markets are highly corelated and current valuations leave risk asset prices vulnerable. We continue to believe investors should not be fooled by the strong outcomes across the board in 2019. Historically, some of the best years for investors are very late in the investment cycle (1999, for example).
It is through this lens that we view the latest developments in markets on the back of COVID-19.
The coronavirus shock
COVID-19 is a “shock” to the global economy, with implications for both the supply side and the demand side. While its long-term effects are uncertain, it is already having a material impact on supply chains, travel, tourism and confidence, which will take some time to be clarified.
Factories in China have been reopening but still suffer from a severe shortage of workers. Apple has already stated they will miss their revenue guidance this quarter, due to iPhone supply being temporarily constrained. In fact, almost 38% of S&P 500 companies mentioned the coronavirus during the January–February earnings season, although many are still themselves uncertain of the impact it will have on their earnings.
The disruption so far will have a pronounced impact on Q1 growth outcomes globally, and will likely extend beyond this period, with limited evidence to date that this crisis is abating. It could be enough to tip key economies into recession. At the very least, the risk of recession is now elevated.
The market reaction
We were surprised by the positive equity market moves in the initial phases of the virus, as investors assumed the positive benefits of Chinese stimulus while considering few of the downside risks. Many comparisons to the 2003 SARS outbreak and market rebound were made.
Our view was, and remains so, that China’s role in global supply chains is much more critical today than before and that we are starting from a much weaker position in terms of both economic fundamentals globally and monetary dry powder.
Central banks (and governments) will respond. The US Fed and the RBA have already cut rates. We will also likely see a fiscal response in Australia as the government deals with a series of shocks impacting the local economy. While the playbook of late has been for markets to respond favourably to central bank support, the headwinds may be a bit stronger this time around, with the pronounced yet uncertain economic and social implications of COVID-19 yet to be fully understood.
Our portfolio position
We were relatively well positioned for the COVID-19 outbreak and its spill-over into markets – not because we had any special insight or forewarning, but because our investment process had been clear on the point that valuations were stretched and risk premium narrow. This made markets vulnerable to any shock that pushed the economy off its narrow and optimistic path, even if the timing was impossible to predict.
Against this background, we had broadly looked to:
- keep overall risk levels moderate
- skew the portfolio to those areas we felt offered the best risk-adjusted rewards (in our preference for Australian equities over the US, for example)
- reduce our exposure to developed market corporate (especially US) credit risk, and
- pre-position for recession without actually adopting the recession portfolio (our own version of “Doomsday preppers”).
In environments like late February, there are often few places to hide, so asset allocation matters a lot – particularly with the overall balance between risk asset exposure and more defensive risk hedges being the key driver of performance outcomes.
At the start of February, our exposure to equities was close to 25% of the portfolio. This is a position we have cut further and, by month end, our exposure was closer to 20%. However, this did drag returns down, with equity markets falling over 10% in most regions.
Similarly, we’ve been cutting back our corporate credit risk, firstly through the US high yield CDX market, and more recently by looking to switch from global investment grade credit (where we perceive the upside to be limited) towards a combination of equity and sovereign bonds. We also held off on the equity leg, given the level of equity markets and concern about valuations.
However, our risk hedges have worked effectively to mitigate much of this drag. The most effective of these has been the management of duration. We have been building up portfolio duration over the last 18 months, from a low of around 0.75 years in mid-2018 to over 2.6 years at present (including some additional duration added in late January and February 2020. With US 10-year bond yields dropping 0.5% during February, this contributed significantly to performance.
The second important factor mitigating downside risk was our short AUD and long USD position. The sharp decline of the AUD in January and February has helped support returns and offset the weakness in both equity and credit markets.
The critical question, however, is where to next? While equity markets are down around 10–12% from elevated peaks, we think there is still more downside, given the near-term uncertainty around the COVID-19 outbreak and its economic and policy ramifications. Writing at the beginning of March, we believe markets have yet to fully reflect these risks and restore adequate or attractive risk premium to markets.
This leaves us cautious and on the sidelines with respect to risk assets. Context is important and, despite the sharp drops in recent days, price levels for many equity markets are only back to the levels of the first half of 2019. The most obvious catalysts for re-entry into equity markets would be a clear improvement in market valuations, evidenced in lower prices, or signs that the risks around COVID-19 are being managed and reduced.
On the defensive and risk hedging side, it’s possible that aggressive central bank action could ensue which would drive treasury yields down further – as we know that 0% is not necessarily the lower bound. For now, we will hold our elevated duration positioning, as well as our broad currency positions.
The next few weeks and months will provide further tests of the difference between diversification and hedges. We have already witnessed some alternative asset classes move in tandem with equity markets while others have trended sideways. We have not, however, observed wholesale positive breakouts. Once again, time will tell.
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