Quarterly Market Update – April 2020

April 2020

Market Update

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.

 

A Really Good Thing

After the jaw-dropping 35% decline in the markets from February 19th to March 23rd, the stock market rebounded over 22%, including one of the best weeks in recent memory.  Could this be the start of the much-hoped-for V-bottom recovery?  Is the Coronavirus-induced bear market over?  Moreover, how bad is the economic fallout going to be from the social distancing and business shutdowns?  Let’s tackle these one at a time.

First, it is highly unlikely given the lingering uncertainty about the Coronavirus and the economic shutdown to expect a V-bottom recovery.  It seems more appropriate for the recovery to come in the shape of a W-bottom, with multiple retests of the lows in between powerful, short-term rallies, like what we have just witnessed. Extreme volatility is here to stay, at least in the near term, driven by positive and negative news related to COVID-19.

Social distancing may be working…  Second, while there are increasing signs that the rate of growth of infections is slowing, it is too soon to declare victory.  As the world listens to Dr. Fauci and other health experts, we can share a glimmer of hope, but we must remain vigilant in terms of following their guidelines to mitigate the spreading of the virus. 

But at what cost?…  Herein lies the most difficult question, and one with no clear answer at the current time.  The pressure to reopen at least part of the economy is growing by the day.  So is public frustration with politicians who see the opportunity to take over more control of everyday life, whether driven by good intentions or an insatiable thirst for power.  Let me be clear.  In crisis, we all expect and want the government to step up to the plate and do what it can to overcome the challenge at hand.  However, we also expect government not to go too far and let us get back to a normal life once the challenge has been defeated.  It’s a difficult balance and unfortunately, imbalances have consequences.         

The process of trying to get the balance right, is likely going to take the rest of this year, if not longer.  There will be periods when government initiatives have largely positive results and other periods when the opposite occurs.  It’s just going to be a volatile process.  Then, lest we forget, there is an election in seven months, which could upset the apple cart as well. 

How to invest in uncertain times?…  Underlying valuations for most companies will be much more stable than their stock prices, which will be battered by positive and negative developments related to the pandemic, as well as government initiatives.  Patience and valuation discipline will be critical to take advantage of this extreme volatility. 

Earnings season has arrived…  Generally speaking, earnings expectations are very low, and we expect conservative guidance for the remainder of the year.  It will be interesting to see how the market will react to lower earnings and any reductions in guidance going forward.  Everyone understands the economic shutdown is going to be a stiff headwind for corporate profitability, so it is not out of the realm of possibility to see some positive earnings surprises.  We are not expecting positive surprises to be widespread, but if a few bellwethers surprise on the upside the market could rally sharply.

Businesses are retooling…  Businesses large and small are retooling.  Non-health care manufacturing companies are finding ways to produce personal protection equipment that is currently in great demand.  Companies are rethinking their supply chains hoping to become less dependent on China.  Restaurants are trying to survive by offering delivery and curb side pickup.  My point here is that America is responding to the pandemic in multiple ways.  Before COVID-19 arrived on the scene, America may have been complacent.  Why wouldn’t we be?  Life here for most of us was pretty good.  Now we realize we are all in this together.  Well, maybe politicians haven’t realized that just yet, but they are followers, not leaders.  The real leaders are leading.  They are our doctors and nurses, small business owners, neighbors and volunteers, and individuals in all walks of life doing the best they can to stay healthy and help others in need at the same time.

Everything we do to stay healthy and every creative way we find to help others matters in this battle.  The much-needed unification of our country is starting.  We have a long way to go, but this is a really good thing.       

 Michael Kayes, CFA

General Market Update, March 24 2020

Financial markets have been exhibited a historically high level of volatility across asset classes. We expect the volatility to continue over the next few months as there remains a wide range of views as to how disruptive the Coronavirus pandemic will be to both businesses and the broader economy.


Below is a high-level overview of the current situation:


• A decade of accommodative central bank monetary policy (artificially low rates and liquidity injections) drove global investors to take excess risk in search of suitable returns. This created a global asset bubble across both public and private investment markets.
• We started to see signs that the bubble was stretched in Q4 of 2018 as well as during the September repo crisis. In both cases, the central banks were able to prevent a total unwinding of positions by responding with further rate cuts and capital injections.
• Coming into this year it was clear that global growth was materially slowing, and central banks were running out of ammo. Europe and Japan already had negative interest rates. Additionally, the Fed had taken the U.S. down to sub 2% interest rates and was already expanding their balance sheet again. So, it was only a matter of time before an external shock hit the economy and caused a problem.
• The Covid-19 virus pandemic is a particularly nasty external shock. The virus is highly contagious and has a high hospitalization rate, which forces economies to essentially self-quarantine for a period if they are unable to contain the initial outbreak. Even in the best-case scenario, most major markets will be forced to enact Draconian measures through much of 2020 to try to beat back the virus.
• The market is currently exhibiting historically high volatility. This is partly due to Covid-19 concerns. Though the bigger driver is the build-up of systemic risk over the last 12 years. There is a shortage of dollar liquidity that is forcing market participants to simultaneously unwind trades across asset classes.
• A global recession is looking highly likely at this point. Recessions can span the spectrum from mild to severe. It’s too soon to tell where we will fall on that spectrum.
• The Federal Reserve Bank has already announced a variety of programs intended to inject hundreds of billions of U.S. dollars into financial markets to ease funding pressures. The Bank of Japan, European Central Bank, Bank of England, and other major central bank entities have followed suit.• Additionally, sovereign governments are mobilizing massive fiscal stimulus plans to support their respective economies.
With that background in mind, below is how we were positioned ahead of the pandemic outbreak and how we plan on addressing the positioning of our strategies.
• Fortunately, we were already positioned conservatively across our various strategies including historically high holdings of cash and/or gold and relatively higher-quality credit exposure than the broader market.
• We are not going to try to “time the market” by making any sudden, drastic changes to our strategies. There is no way of knowing when the cross-asset liquidations will abate. Much will depend on how successful the Fed’s actions are. Additionally, much of the poor economic news lies ahead of us in the coming months.
• In our equity strategies we plan on slowly putting our cash and gold to work as we see signs of market-wide stabilization. We are looking at many internal market indicators to get a sense as to when the liquidity pressures have turned the corner including the short-term funding markets and spreads in fixed-income products.
• As the markets declined our cash balances naturally rose to as much as 18-20% in some strategies. We have put a small amount of money to work in some of our favorite businesses.
• We have started the process of rotating out of some of our existing exposure that was either “defensive” or “crowded/overvalued” and into some of the hardest hit areas of the market that are broadly trading at their lowest valuations since the Financial Crisis. We are highly confident that these names will generate strong long-term returns, but they continue to show extreme volatility. Consequently, we want to be slow and methodical with the pivot to a more aggressive posture.
• There is still a wide gap between some names that continue to trade at historically high prices (e.g. Tech stocks) and names that are pricing in a global recession lasting several years (e.g. Industrials, Energy, Financials). It is likely that this will be a rolling process spanning many months as each stock follows its own path to a reasonable valuation. These nuances offer us opportunities to add long-term value if we are patient and disciplined.
• We continue to believe gold is a good diversification tool in our strategies. To this point it has done its job by holding its ground along with cash. It typically comes under pressure at the precise moment that liquidity dries up since gold is highly liquid and exchangeable into any currency. Where it tends to shine is once the central banks start massively expanding the balance sheet. So, the current setup is very bullish.

We will likely put cash to work before gold for this reason.
There are two legs to every cycle. The down leg – in which we are gaining a lot of alpha due to our conservative positioning going in. And the up leg – where big returns are possible if you have liquidity available and take advantage. It is important to keep that whole cycle in context.

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