Portfolio choices in a post-COVID-19 world

The recovery in global stocks continued last week. The S&P 500 and the Euro Stoxx 50 are now 29% and 21% above their March lows respectively. Equity volatility also declined, with the VIX dropping 9 points last week to 28, the first time it has fallen below 30 since late February, prior to the collapse in equities.

With markets stabilizing, the questions our clients are asking at our livestream events reflect concerns over what is the best portfolio mix. Is traditional asset allocation still of any use? Should you hold more cash? Here we answer these and other frequently asked questions.

1. Is there a future for traditional asset allocation in a zero/negative interest rate regime?

The principles behind traditional asset allocation remain intact, including diversifying across asset classes to reduce individual risk and allocating across assets to maximize expected returns for the desired level of risk.

But, the choice of assets within portfolios can shift to take the low interest rate regime into account. Financing elevated government debt levels will likely require a combination of financial repression, taxation, and moderately higher inflation. This combination will amount to an effective tax on conservative savers, and so will therefore require investors to reconsider the place of bonds and cash in their portfolios. Alternative diversifiers including option strategies, dynamic allocation strategies, and private markets will need to play a bigger role, as well as assets like gold and TIPS, which may additionally provide protection against the risk of higher inflation. Potentially higher tax rates, combined with elevated financial market volatility, will also increase the importance of financial planning and strategies like tax loss harvesting. More on alternative diversifiers here.

2. How do you explain the discrepancy between equity markets (pricing more toward your upside forecast) and credit (more toward your downside)?

The difference arises from the drivers behind the valuation of each of the two asset classes. Credit spreads reflect a liquidity premium, probability of default, and an expected loss. An equity price reflects the net present value (NPV) of all expected future dividend payments. In March when markets collapsed and price movements across different asset classes were highly correlated, both equities and credit fell sharply. This was to be expected since markets were pricing in an increased probability of defaults, and if a company defaults, then you don’t expect there will be future dividend payments. In addition, during the sharp market fall liquidity premiums increased significantly, which impacts credit more than equities because it is a less homogenous asset class and is traded in larger minimum denominations than stocks.

Now that the large scale and rapid policy response from governments and central banks has made a depression-like scenario far less likely, equities have priced in a sharper recovery than credit. This is because equities are looking through the near-term weakness and pricing all future cash flows over an unlimited time horizon. Credit, in contrast, is more focused on the fact that short-term default risk remains elevated. In fact, many credit curves are flat or inverted, reflecting a belief that if a company defaults it will be in the short term and not the long term. More on credit opportunities here.

3. Have we already seen the bottom in equity markets?

Global stocks have rebounded strongly off their March lows and are now broadly pricing in between our central and upside scenarios. Fiscal and monetary stimulus, enacted with unprecedented speed and scale, have aided that rebound, and we expect policymakers to remain supportive in their efforts to recover from the coronavirus-induced economic slowdown.

Meanwhile, economies are slowly easing suppression measures, and medical developments have also been positive. Taking history as a guide, much of the worst selling could be behind us. In the seven bear markets since WWII, the average drawdown was around 34.5% for US large-cap stocks such as the S&P 500.

In the March sell-off, we saw a maximum drawdown of 33.9%. But that doesn’t mean we can rule out our downside scenario, in which we see the S&P 500 fall to 2,100 by year-end. This could be triggered by a significant second wave of virus infections as economies reopen, resulting in an inability to sustainably restart economic activity until around June 2021. To protect against this scenario, we recommend investors hold an adequate level of high-quality bonds; consider dynamic asset allocation strategies that can adjust equity exposure in response to changing market conditions; and incorporate alternative diversifiers such as gold, TIPS, hedge funds, and structured solutions with a degree of capital protection.

4. Given the uncertain outlook, isn’t holding more cash a good idea?

Many investors have sought out the perceived safety of cash during the COVID-19 crisis. Assets in US money market funds have grown to around USD 4.7tr, increasing by more than USD 1tr in the space of eight weeks, according to data from the Investment Company Institute. By comparison, during the last global financial crisis in 2008, money market funds grew by less than half a trillion dollars. And the crisis has underlined the importance of maintaining adequate liquidity and avoiding over-leverage. Doing so allows investors to meet their obligations without being forced to sell in falling markets.

But while rushing to the exits may feel like a safe choice the real value of cash is eroded over time by inflation and we think there are several better alternatives to holding excess cash over and above your liquidity needs. We see opportunities in credit, which is closer to pricing in our downside scenario, and within equities we recommend building up long-term positions through an averaging-in strategy. For investors who can implement options, put-writing can help to reduce the opportunity cost of a phase-in strategy. In addition, we think a selective approach in equities may help sidestep some risks, and see particular opportunity in select cyclicals, stable and defensive stocks, and longer-term themes likely to be accelerated by COVID-19.

5. What is your view on gold in this environment of massive QE and very low rates?

We see two roles for gold in the current environment. The first is as an alternative portfolio diversifier. Given the accommodative stance of central banks, including the huge extension of quantitative easing programs, we expect rates to stay low for an extended period. With low yields available on long-term government bonds, the downside protection from nominal bonds will be more expensive, meaning investors may need to consider alternative portfolio diversifiers such as gold and Treasury Inflation-Protected Securities (TIPS). The second role is as protection against future inflation. The experience of the last decade has shown that generating inflation is not straightforward. But given the risk that potential debt monetization leads to higher inflation, gold and TIPS can provide inflation protection. We have a positive view on gold over the next 12 months because we expect real interest rates to fall deeper into negative territory, we expect the dollar to depreciate as economies recover, and we see equity market volatility persisting.

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