Investors have witnessed the fastest bear market in history as well as an equally breathtaking rebound in global equities, all in the first half of 2020.
On the surface, this bear market may now look like a flash in the pan, like that seen in US equities in late 2018, which was followed by a return to new all-time highs in early 2019. In contrast to 2018-2019, though, as investors emerge from this abbreviated version of a global bear market they are confronted with an economic, corporate and geopolitical landscape forever changed by the fallout from the global coronavirus pandemic.
Investors are now faced with governments having abandoned both fiscal and monetary restraint in favor of a “whatever it takes” policy approach.
In addition, the ever-rising use of debt to sustain corporate earnings and consumer lifestyles is likely to be a casualty of the post-COVID world, leaving growth prospects increasingly uncertain and profit models and household savings targets to be reassessed.
Compounding these challenges are geopolitical shifts, occurring across multiple axes. In regards to the US-China trade war that began in 2018, the truce struck between the world’s largest economies in December 2019 now looks broken, with America pressing its fight with its geopolitical rival. The May 2020 Franco-German proposal has the potential to change the North-South divide within the EU, while the yearend Brexit deadline draws ever closer.
There is also the potential for a second round of outbreaks, a surge in post-lockdown business bankruptcies and structural unemployment. As a result, even though the tragedy of the global pandemic is still playing out in many economies around the world, investors must use the current respite in markets to re-anchor their portfolios within the rapidly shifting investment landscape.
The first priority is to recognize that government bonds in particular, but also bonds in general, may no longer be the safe havens that many investors had hoped.
Though long-duration US Treasuries have served their purpose in protecting portfolios by rallying 10% during this crisis, yields are now perilously close to zero and the experience of German Bund investors during the March selloff is instructive. German yields were already consistently below zero before the outbreak, so German bonds did little to mitigate the fall in risky asset prices, delivering a modest 1.4% annual return at the time of the March equity market trough.
Now that US Treasuries are yielding near zero, and assuming Fed Chairman Powell’s guidance against negative interest rates holds, they—like German Bunds before them—will become at best a capital preservation solution rather than a credible offset to risky asset volatility looking forward.
In light of this, investors should turn to other strategies to protect portfolios against the possibility that central bank firewalls against a wider credit crisis will once again be tested. In particular, gold should make up a significant proportion of portfolios. Central banks around the world have demonstrated a low pain threshold in their battle against deflation before turning to their primary policy tool of printing money. This is now a standard response, and provides a tailwind for gold if shocks to global stability were to re-emerge.
Pairing gold with safe-haven currency exposure in Swiss franc and Japanese yen can help to recreate the refuge previously offered by government bonds within portfolios.
With the ballast in portfolios reestablished, investors can turn their attention towards return generating assets. Even here, however, risk-averse investors should revisit the assumption that credit exposure carries lower risk than equities. As seen in the March selloff, both USD investment-grade and high-yield credit delivered peak to- trough losses of 18%, providing only relative shelter against the 30% decline in global equities.
Fortunately, overt Fed purchases of investment-grade credit should provide investors some protection from renewed liquidity events. Indeed, ECB purchases allowed EUR investment-grade paper to outperform its USD equivalent during the March selloffs.
In riskier credit arenas, with the CBOE equity-market volatility index (VIX) having fallen to below 30 in the second quarter, investors can once again use option strategies cost-effectively to protect not only equity exposure but also riskier credit exposure, such as high-yield bonds or emerging-market debt, against a likely rebound in volatility.
The implied backstops offered by the US and eurozone central banks can therefore be combined with explicit protection via option strategies, allowing investors to not only actively manage their exposure to the various tail risks they face in a post-COVID world, but also focus with greater confidence on active credit and stock selection to drive returns.
Looking at the eurozone and Japan, where slow economic growth and activist central banks have transformed swaths of their domestic corporate sectors into zombie companies, a growth and quality bias in stock selection has allowed investors to navigate these challenging environments. With the global economy increasingly facing the same issues, we expect a similar bias will reward investors in the wake of the current crisis.
Investors can also look to capitalize on the disruption caused by policy responses to the global pandemic— including an expected surge in biotechnology investment—as well as by the shift in the US-China power balance and by the reduced power of leverage as a driver of consumer spending and value for global corporates. Together, these trends should reinforce the value of company-level analysis in generating returns, via active stock selection.
Investors should benefit from the acceleration of long-cycle trends, including the deepening of technological solutions that are spurring the transformation of the pre-COVID economy as we enter the post-COVID world.
The localization and regionalization of global supply chains in the coming years should create intra-sector winners and losers, much as globalization two decades ago favored first movers among companies as well as investors.
As a result, while uncertainties still abound in the face of this devastating global pandemic, investors should look to re-anchor their portfolios first by reshaping their protection and then by capitalizing on opportunities, drawing on lessons of the past—in Europe and Japan—as well as by actively looking forward to what the future holds in industries like healthcare and technology.
CIO Wealth Management