Apr 28, 2020
The first quarter was dominated by three shocks to markets: the coronavirus (COVID-19) global pandemic; an oil price war between major energy producing nations; and the consequent market weakness resulting in disorderly price action and dislocation across all asset classes. As a result, central banks and governments moved to ease policy aggressively in seeking to support the functioning of financial markets and assist the household and business sectors to an unprecedented scale. The US Federal Reserve (Fed) alone, for example, expanded its balance sheet by almost US$1trn in the space of just two weeks.
Growth assets universally generated negative returns. Oil was by far the worst, falling 70% from peak due to falling demand and increasing supply. Equities across the board struggled with almost all major indices posting double-digit losses and UK and emerging market equities among the worst performers. Chinese equities were the relative best performer. Real estate stocks fell, while an exodus from emerging market assets saw yields on sovereign debt rise as prices fell leading to double-digit losses for both local and hard currency debt. Credit spreads rapidly widened towards the latter half of the quarter leading to 10-20% falls across credit and an implied default rate several times higher than that seen in a typical recession.
Traditional defensive assets offered limited shelter, with developed market bonds delivering a small positive return as yields fell, although not consistently. Continued flows into the US bond market saw the 10 and 30-year Treasuries rally as their yields dropped to record lows yet again before pulling back in the second half of March. The US dollar demonstrated ‘safe haven’ characteristics although with some volatility during March. The Japanese yen and gold performed well, though the latter’s price action proved unstable. Investment grade credit was a notable underperformer, driven by investors’ rush to raise liquidity.
We began 2020 with a net equity position of c.20% as we had become more constructive towards growth assets due to supportive policy by central banks globally, as well as our leading indicators pointing to a smaller risk of recession and increasing signs of a bottoming in economic data. Though more demanding asset valuations and late cycle dynamics meant we continued to hedge one third of our physical equity exposure. The spread of the coronavirus to Europe, the US and the imposition of severe lockdown measures prompted us to quickly and meaningfully reduce exposure, taking net equity to a low of 7% by mid-March. Given the scale and speed of the sell-off, we redeployed some hedges which allowed us to participate in the in the relief rally towards the end of the quarter. Overall our hedging process worked well and contributed positively to returns, offsetting approximately half of the losses suffered by equity positions.
However, the COVID-19 related economic shutdowns led to a sharp fall in most asset classes except for major government bonds. The Fund’s equity exposure lost value, with higher yielding equities generally underperforming the broad market, although our bottom-up stock selections proved their worth in navigating this stylistic headwind well. Property holdings also sold off sharply. However, the surprise was the significant rise in yields (and therefore fall in value), especially for investment grade rated bonds and those in the higher-rated parts of the market, with yields moving proportionately more than the fall in equities would normally have suggested. The falls in both equities and credit provided a useful reminder of why we do not rely on bonds generally and without differentiation as an offset to equities. Furthermore, the dislocation in the corporate bond markets now provides an attractive future return opportunity assuming spreads normalize as they have done in historic periods of extreme widening. Our modest duration position provided a small offset. Emerging market bond markets held up relatively well in the circumstances, despite being a moderate drag on returns. Exposure to the Japanese yen – a currency typically regarded as a safe-haven – was positive for returns in the risk-off environment.
What has been most notable in the market drawdown year-to-date is the underperformance of higher yielding assets, which has been true across and within asset classes. Despite this, the Fund performed reasonably well in Q1 2020 – another period like 2018 of severe sell-offs in asset prices with a lack of offset by traditional safe havens and other well-known diversifiers such as infrastructure and high-quality corporate bonds.
The level of portfolio activity was relatively high during Q1 2020 as the indiscriminate sell-off gave us an opportunity to buy high-quality companies at discounted valuations. We increased our credit exposure at attractive entry points given the extreme dislocation in those markets. Since the beginning of the year, we increased high yield exposure by c.2% to c.9% of NAV, while we increased exposure to investment grade by c.4% to c.21% of NAV, funded by a reduction in developed market sovereign bond exposure. These changes were beneficial for performance as spreads started to normalise and tighten over the course of the last two weeks of the quarter. Looking forward we expect credit to be a meaningful driver of the Fund’s total return and income. The thinking behind this is that credit outperforms equity early in the economic cycle – which is where we believe we’re heading.
We reduced net equity from c.20% at the beginning of 2020 to a low of c.7% by mid-March (at the height of the sell-off). Following the major policy response, equity valuations became more attractive which presented opportunities in the medium term, so we increased net exposure back to c.15% by the end of March. This allowed us to participate in the relief rally seen in the final week of March. Beyond this there was some turnover in the equity book with four names being sold that no longer met out bottom-up selection criteria, and five names added which offered an attractive and sustainable yield as well as the potential for capital growth.
Exposure to emerging market debt (EMD) has remained broadly stable year-to-date as the focus has been mostly on developed markets. The allocation has been relatively consistent through time, with almost all exposure currently in local currency. We focus on countries where we can obtain a high degree of yield, but with little duration risk; short duration bonds and hedge the currency back to US dollars – the Fund’s base currency. We do not currently anticipate making any meaningful changes to this allocation. Although smaller in size, as a result of the COVID-19 induced market sell-off we added to listed infrastructure as these assets were also hurt leading to them trading at a discount. We continue to build this position as liquidity allows; it is currently around c.1%.
The immediate risks remain challenging. While our central case scenario is that following a short-term shock to growth the policies of strict isolation coupled with the rapid and meaningful response by policymakers are able to curtail the impact of a deep recession, we still assign 35% probability to our downside scenario as there are a number of issues that could derail our central case. In particular, there is a risk that lockdown measures fail to contain the virus and the extended disruption is too much for businesses to withstand, even with the significant policy support. This would result in lower valuations than current levels, which would in turn be emphasised by the price/earnings ratio of the market, which is still above levels typically seen in a crisis. Therefore a ‘V-shaped’ recovery is unlikely, and past instances of such vicious market moves have taken many quarters to resolve. As such, we continue to hedge approximately half of our equity exposure, running with a relatively low level of net equity, but with scope to increase and participate in equity upside should the risk environment improve.