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 Willingdon Wealth Management. No representation is made as to the accuracy or completeness of this information