In the first couple of months of this year, markets had been building upon the momentum they had established throughout 2019. These moves, however, failed to appreciate the brewing threat the Coronavirus outbreak which was working its way through China would have on the health of the global economy. Stock markets in Asia had suffered even before the Chinese New Year market holiday in late January, with many tourism-related names being the worst hit. Western stock markets had done little to adjust to the outbreak with the lockdown of Wuhan, Central China’s largest city and the epicentre of the outbreak, expected to prevent it from spreading further afield.
This soon changed with the emergence of a number of European cases, initially in Italy, sparked a global investment market selloff due to the potential of a broad-based negative impact on company earnings worldwide. Since then, COVID-19 has spread across borders and through populations at a rate that few expected. Governments worldwide have been enforcing policies to restrict all but the most necessary of tasks whilst central banks have been engaged in direct market participation at a scale never previously witnessed. The MSCI World US$ Index, which priced at 2,434 on February 20th, fell by 35% to a level of 1,579 just 22 trading days later on March 23rd. We have in recent days begun to see the spike in market volatility begin to subside as well as shoots of optimism start to emerge in the global fight against the Coronavirus pandemic.
Against this backdrop, we are keen to share insights we have gleaned from the teams and managers responsible for our selected funds and describe our thinking behind model portfolio construction from both an asset allocation and fund selection level.
Firstly, I have included two high-level comments regarding the impact of Coronavirus from both an equity manager and fixed income manager perspective.
“Had anyone told us at our team Christmas dinner last year that Ryanair would cancel 80% of its flights in Q2, LVMH would start producing hand sanitiser, and our offices around the world would shortly be closed, we would have had a hard time believing them. The COVID-19 situation is surreal, and without any comparison. The latest developments of the Coronavirus have seen numerous countries shift into lockdown mode, which is creating a global demand shock.” Allianz Continental European (European Equity Fund)
“After such dramatic moves in markets, the big question is what is now being priced in. Squeezes in liquidity are creating large swings in prices but at the moment recession is 100% priced into investment-grade spreads… Thanks to historically low yields, most companies’ balance sheets are resilient, with refinancing pushed out further down the line. And default rates may not reach the same level as in previous recessions. Apart from in those sectors such as oil and retail which will bear the brunt of this pandemic.” Artemis High Income (£ Strategic Bond Fund)
Despite these dramatic moves, there are also certain factors which may be cause for optimism. As a consequence, it is interesting to glean what trades and changes (if any) are being enacted under the bonnet of our chosen funds to navigate these uncertain times.
“We have been using the sell-off in credit as an opportunity to begin adding back credit risk, albeit being fully aware that the next few weeks will be a challenging time from a news flow perspective and markets are quite likely to roll down to even lower levels. This is the beginning of an averaging in process and we need to get going.” Janus Henderson Strategic Bond (£ Strategic Bond Fund)
“We did sell our holding in Marriott Hotels at $143 (taking a profit) before the full panic relating to the virus took hold. The shares are now $86 and we may look to buy back in again once the market finds a bottom. Smaller companies have been severely marked down and having moved out of the sector a number of years ago (the Russell 2000 Index has drastically underperformed the S&P500 Index over the last six years) we have started to rebuild exposure as we expect this asset class to lead coming out of a downturn and a recession looks quite likely at this point. Thus far we have invested about 4% in niche growth stocks in the healthcare, software, semiconductor and business services sectors. We intend to opportunistically increase the fund’s small-cap weight over the coming year now that valuations are more attractive.” LF Miton US Opportunities (US Equity Fund)
“The fund sold its subordinated Heathrow bond at 260 bps wider than its tightest trading level to buy Aéroports de Paris new issue today, which has widened an equivalent of 240 bps since its best level this year. The Heathrow subordinated bond is rated BB, the Aéroports de Paris senior bond is rated single A. Heathrow has much higher leverage. Aéroports de Paris is 51% owned by the French state. This goes to show you can rotate out of higher risk bonds and improve quality without much compromise on returns if things improve. If they go worse, I’d far rather have senior debt with the French government behind it than a deeply subordinated Heathrow bond with much higher leverage and a Chancellor who has already warned that Airports shouldn’t be expecting assistance, given they have been paying their private owner's healthy dividend.” Artemis Corporate Bond (£ Corporate Bond Fund)
“Due to our long-term focus, the team are not going to look across the portfolio as a whole and make a knee jerk decision on market timing. However, we are continuing, as always, to evaluate and monitor individual franchises, on a case by case basis, with the intention of adding quality companies at a lower valuation.” Steward Investors Asia Pacific Leaders (Specialist Asian Equity Fund)
The overriding theme from many of our managers is certainly therefore not one of panic. Instead, our managers are very much taking a calm and collected approach across the board as we would expect, with some long-term opportunities being picked up on across different regions and asset classes. Even in the case of these opportunities, our managers are often waiting for the current market volatility to reduce before building long term positions in new holdings. Some trades have been executed which are small relative to the size of strategy, but the underlying message of these trades has been one in where the quality of investments held has been improved as a result.
It must also not be forgotten that for passive index strategies, as a percentage of their fund size, the exposure to quality stocks and investments will also have increased. This is due to investments which are seen to be of higher quality generally outperforming through recent months. In many of our models, we hold a price-weighted index strategy. The same effect will still be evident here however, with the price of lower quality companies falling in price and therefore in price-weighted index weight by extension.
Fund manager outlooks
Whilst the reaction of managers and gleaning insight into trades they are executing is interesting, it is also important to relate these with the market views and impact they foresee the Coronavirus pandemic having upon investment markets over the coming weeks and months.
“This crisis will take some time to work through and the lack of clarity together with negative news flows will tend to depress risk appetite in the near term. The most appropriate thing to do in such situations is not to overreact, but to remain calm and pragmatic and this is what we always have been doing in our key strategies. We continue to focus on how the real economy will be impacted and how valuations will evolve. Currently, we believe that while there will be an impact on GDP, this will hit mainly discretionary spending (travelling, restaurants, cinema) while the labour market is unlikely to be materially affected.” M&G Optimal Income (£ Strategic Bond Fund)
“News flow over the next few weeks is likely to be pretty grim and uncertainty is unhelpful. But this will pass just as the financial crisis of 2007/08 passed. I remember Monday 19 October 1987 as though it was yesterday- and it felt a lot worse. All Bear Markets have a different cause, but they also pave the way for the next bull market.” Montanaro UK Equity Income (UK Equity Strategy)
The approach prescribed by our investment committee process is one which is long term in nature. As a consequence, we, just like our managers, are not reacting in knee jerk fashion. Instead, we continue to survey the investment landscape for the asset classes which we favour with the long-term investment horizon of yours, and ours, in mind. Whilst we are yet to see the numbers of cases peak around the world and remain a long way from being out of the woods, markets will at some stage have efficiently priced further bad news into their expectations.
Within our model portfolios, we have a blend of funds across different aspects of the investment market. This enables our portfolios to benefit both from a range of market views as well as from different regional market exposures. In the current scenario, where we may see continued weakness in some regions, with a potentially simultaneous recovery in others (where the Coronavirus is having less of an economic impact) the diverse regional market exposures we maintain may once again prove to be advantageous. Furthermore, the committee continually assesses the funds which we have selected within each area and make sure they are appropriately weighted within portfolios bearing in mind the level of risk tolerance appropriate to each of our mandates.
Whilst we don’t have a crystal ball and do not dismiss the likelihood of markets getting worse before staging a recovery, we are optimistic that at some point markets will begin to extrapolate the long term earnings potential of companies once more and reappraise asset prices on this basis once again. We are confident that on a long-term view, the prices which assets fell to during March will be looked back on as having been a good opportunity for long-term investors to purchase long-term investments.