Apr 28, 2020
For the quarter, the portfolio delivered negative absolute returns, underperforming its benchmark.
The portfolio produced a negative absolute return in US dollars, gross of fees , underperforming its benchmark. The equity allocation detracted, with markets globally entering a turbulent period driven by the combined impact of the coronavirus pandemic and an oil price war between Saudi Arabia and Russia. These shocks contributed to dislocations in credit markets, one of the most rapid declines in developed market equities in the past century, and what is set to be a sharp contraction in global growth. As a result, central banks and governments have moved to ease policy aggressively in seeking to support the functioning of financial markets and to assist the household and business sectors through what is set to be a very. challenging period. This helped markets regain some ground in the second half of March. The largest detractions came from US equities and from the financial sector in particular, with US mortgage insurance and large cap bank exposure suffering notable weakness. Asian equity positions fared somewhat better as China showed signs of recovery as the early onset of the virus and associated economic shutdown began to abate by the end of the period, with digital consumption names such as Alibaba and Netease performing relatively well.
Return contributions from the portfolio’s fixed income positions were also mixed as developed market bonds rallied following emergency rate cuts by central banks in light of a deterioration in growth outlooks. A long position in Canadian short dated government bonds added to performance, while positions in curve steepeners neither contributed, nor detracted over the period. Positions in emerging market debt sold off driven by a stronger dollar and a pickup in global recession fears, with notable weakness in South African and Russian positions. In contrast, the portfolio’s position in gold added to returns as it appreciated over the period.
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$1 trillion 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.
The portfolio had been positioned for an emerging economic recovery entering 2020 and we saw strong return potential from the portfolio over a two to three-year horizon based upon the balance between attractive valuations versus strong underlying fundamentals in the portfolio’s active positions. As such, the portfolio entered this turbulent period with an overweight equity position and an underweight exposure to developed market government debt, due to extended valuations, but with a high cash balance.
Although uncertainty about the future remains high, the sell-off and dislocations in financial markets have now created compelling investment opportunities for medium-term investors, in our view. So far, we have used this sell-off in markets to begin to deploy the portfolio’s cash balance – buying the shares of companies we have wanted to own in the past, but had been held back by prior elevated valuations, and adding to existing positions, as well as building exposure to developed market credit where dislocations have been particularly stark.
Post the sell-off in markets, we added to positions in high quality companies, many with defensive characteristics. In addition, we believe the largest dislocation in financial markets appeared in developed market credit, with investment grade credit spreads having widened materially and disproportionately versus other asset classes, while high yield debt markets haven’t been too far behind. As a result, we used some of the portfolio’s cash balance to build a position in investment grade credit.
The current macro environment displays a high degree of uncertainty and there is a risk of a more pronounced economic downturn that would likely weigh on equity and credit markets further. However, we take some encouragement from the patterns relating to the lockdowns of populations and containment of new infection cases. In addition, we are also encouraged by the steps that authorities have taken in seeking to limit the economic damage from containment measures. On the former, the pattern in China and South Korea has been for new cases to peak and then decline two-three weeks after the implementation of stringent social distancing measures. Similar evidence is starting to emerge in Europe. On policy, the speed and magnitude of the measures being announced and implemented is unprecedented. This differs somewhat from the major economic crises of the past, such as 2008 where it was authorities letting Lehman Brothers collapse that caused trust between banks and businesses to breakdown and broader confidence across the economy to evaporate, amplifying the downturn. It was only in the months after this that central banks and governments then implemented significant measures, amounting to c.22% of GDP in the US, to backstop the system. There were also delays in the 1930s, but it took years rather than months for authorities to respond with adequate measures.
We estimate that the sum of monetary and fiscal packages announced as at 31 March 2020 in the US, eurozone and the UK are 53%, 50% and 36% of GDP, respectively. We believe the aggressive and rapid nature of this action significantly reduces the tail risk of a more pronounced, prolonged downturn, and it should aid a faster bounce back in activity when the time comes.
Financial markets are likely to remain highly volatile in the coming quarters as investors weigh up the economic impact from efforts to contain the coronavirus outbreak, the results and progress of containment measures in suppressing the spread of the virus, and the impact of material monetary and fiscal stimulus. That said, we believe the significant expansion in risk premia and depressed valuations present opportunities for medium-term investors and we will continue to take advantage of compelling opportunities as and when they are presented by volatile markets, while maintaining the flexibility to hedge exposure if we see the likelihood of a more pronounced downturn materialising.