The Coronavirus pandemic collided with systemically vulnerable capital markets and a weak global economy in March, creating the biggest negative shock to the financial system in more than a decade.
The real economy showed initial signs of stress back in January. China’s quarantine and the gradual spread of the virus overseas caused significant supply chain disruptions and job losses (both temporary and permanent). Those impacts began bleeding into financial markets in February. Short-term U.S. dollar borrowing costs began to rise globally as they had in September of 2019 prior to the Federal Reserve Bank’s interventions. This made it hard for entities requiring leverage (both companies and investment vehicles) to proceed with business as usual. In order to raise the necessary capital, market participants began downshifting their operations and/or selling their liquid assets. This position unwinding was then exacerbated by the forced selling by many market participants who had taken advantage of central banks willingness to backstop markets by building profitable trading strategies that relied on leverage, low volatility, and stocks and bonds rarely losing money simultaneously.
By the end of March sovereign governments and central banks had sprung into action to support their respective economies and markets. The Federal Reserve dropped short-term lending rates to the zero bound, expanded their balance sheet by almost $1 trillion in just two weeks, and created several targeted lending facilities to help the flow of U.S. dollars through the system. For their part, Congress passed a $2 trillion fiscal stimulus package supporting the hardest hit areas of the economy. Both the scope and speed of the actions have no historic parallel. Europe, Japan, and China have also contributed significant fiscal and monetary support to their respective economies and markets.
The swift actions taken by fiscal and monetary authorities are a major positive development and have stabilized markets for now. However, we do not yet know whether financial markets have firmed permanently or just found momentary relief. We therefore expect volatility to remain high in the coming months. The Coronavirus pandemic is just now starting to ramp exponentially in the United States and through much of Europe. We expect that it will take months to work through the damage caused to households, businesses, and credit markets.
We continue to feel the most prudent path forward is one of patience and discipline, prioritizing flexibility so we can adapt to the changing landscape.
The S&P 500 declined -19.6% in the first quarter, slightly outperforming the MSCI World ex-U.S. Index (-23.5% in U.S. dollar terms). Japanese Equities declined -16.6% in U.S. dollar terms, holding in better than European Equities (-27.2% in U.S. dollar terms) and Emerging Market Equities (-23.9% in U.S. dollar terms).
Long-term U.S. Treasuries were the best performing major asset class, gaining +20.9%. Investment-Grade Credit (-3.2%) and High-Yield Credit (-12.0%) were both negatively impacted by credit spreads widening.
The U.S. dollar gained +7% in the quarter on a trade-weighted basis as liquidity shortages forced a scramble for the world’s reserve currency. The price of gold in U.S. dollar-terms gained +4% in the quarter as investors continued to value the precious metal’s diversification benefits, particularly in light of the Fed rapidly expanding the supply of U.S. dollars.
Fixed Income Strategy
U.S. 10-year Treasury yields declined 125 bps in the first quarter to 0.67%, hitting all-time lows of 0.54% on 3/9/20. Similarly, U.S. 30-year Treasury yields hit an all-time low of 1.00% on 3/9/20 before backing off to 1.32% at quarter-end.
Investment-grade credit spreads widened out to 260 bps; the widest levels seen since 2011. High-yield spreads also reached the highest levels since 2009 at 880 bps.
While yields have backed up in recent months, the bond rally of recent years has made it difficult to build new bond portfolios with meaningful yields-to-maturity without going out the risk and/or duration spectrum. We continue to believe that the market risks warrant limiting bond purchases to high-quality issuers and shorter durations.
Core Equity Strategy
The strategy was defensively positioned ahead of the market drawdown with historically high levels of cash, a material allocation to gold, and a generally defensive mix of businesses. This positioning allowed us to hold in better than the broader market.
We have begun the process of cautiously adding more volatile exposure in areas such as Industrials, Financials, and Energy. Though we remain generally cautious, valuing the flexibility and optionality of our cash and gold exposure.
Defensive Equity Strategy
The Defensive Equity strategy remains focused on identifying companies with more stable operating results and stock price volatility than the broader market.
In line with the Core Equity strategy, the strategy was defensively positioned ahead of the market drawdown with historically high levels of cash, a material allocation to gold, and a generally defensive mix of businesses. We added some exposure as the market declined, but in general, remain cautiously positioned.
Equity Income Strategy
The Equity Income strategy’s primary goal is to provide reasonable income while also offering the potential for capital appreciation. In February we determined that we could not achieve our 5% income target without taking an unacceptable level of risk. Accordingly, we prioritized capital preservation by liquidating the riskiest exposure in the strategy.
Despite our aggressive efforts to de-risk the strategy, the simultaneous sell-off in equities combined with widening credit spreads weighed on performance. However, we were able to avoid some of the severe losses seen in vehicles that had been designed to maximize income such as mortgage REITS, levered loans, business development corporations, etc. and continue to look for areas where we can capture yield with an acceptable level of risk.
International Equity Strategy
Individual stock valuations generally continue to look cheaper outside the U.S., particularly in Japan. However, the discounted valuations are somewhat justified by industry mix differences and weaker fundamentals in aggregate as well as a translational headwind from the strong U.S. dollar.
We built a sizeable allocation to gold within the strategy with the objective of preserving real purchasing power should global central banks continue down the path of devaluing their respective currencies. This allocation along with strong stock selection has driven outperformance versus the broader International equity universe.
Thematic Equity Strategy
The Thematic Equity strategy was unable to overcome the broader drawdown in global equities, even with a sizeable cash buffer. This is to be expected as the Thematic strategy is our most aggressive equity strategy and thus its optimal phase of the cycle should be after markets have fully bottomed.
We continue to think the strategy’s cash buffer is appropriate for now given the risks present in the market. Longer-term the strategy’s cash allocation will provide dry powder for increasing the aggressiveness of the strategy once we deem the risks acceptable.
These Investment Strategies are not a recommendation to buy or sell any specific security. The comments made are opinions of Exencial Wealth Advisors. No representation is made as to the accuracy or completeness of this information. Results for the Enhanced Yield Portfolio prior to January 2016 were achieved by a prior firm merged into Willingdon. A principal of the previous firm continues to play an active role in the management of this portfolio at Willingdon.