The magnitude of the threat to the economy that covid-19 represented was unforeseen in financial markets. Emerging first in December 2019, reports of covid-19's spread in Wuhan appeared in the press in January. The speed at which both the health crisis and the resultant economic and financial market crises have unfolded was at a far greater pace than we have seen before. Starting in mid-February, markets entered a month of intense pressure with both equity and bond markets falling, in a sell-off that affected all irrespective of geography, asset class and market capitalisation. As the size of the problem became evident, governments were prompted to respond very quickly, and on a larger scale than during the 2008 global financial crisis. Markets have reacted favourably to government measures and volatility levels have fallen from peak levels but remain elevated. During times of extreme stress assets can become very correlated to each other and March was no exception.
Covid-19 has presented immense challenges, but this has been further exacerbated by the breakdown in the OPEC+ oil price agreement and the subsequent fall in the oil price. The effect has been felt far beyond the share price of the oil majors and equity markets, causing significant disruption to US fixed income markets, where the energy sector had been ~12% of the high yield market. Yields are now very high in that part of the market, with defaults in the US energy sector coming thick and fast.
Following the rebound in equities, indices are 10-15% off recent highs. Yet, the global economy has been dealt a serious blow. Unemployment has risen (particularly in the US), dividends have been cut left, right and centre, with companies unable to give guidance. It seems prudent to take a cautious stance with regard to equity risk given the current environment.
What changes have you made in portfolios?
Portfolio allocations to equities had not been high prior to the crisis, but in March we made the decision to reduce equity exposure across portfolios. The reductions were measured, reflecting the risk of making portfolio changes in a period of market turmoil, but necessary to recognise the exceptional levels of volatility and the significant risks to the economy as we move through this crisis. In April, following announcements regarding government purchase of corporate bonds, we felt there was a stronger underpin to fixed income and took the decision to redeploy cash to the asset class. Feedback from clients regarding the changes has been positive.
With hindsight, what could have helped performance during the sell-off?
We tend not to have significant allocations to cash, recognising that clients generally prefer portfolios to be as fully invested as possible, and that it is usually more efficient for them to hold cash separately. We remain mindful of this, but in the face of exceptional market volatility, we increased cash levels temporarily to reduce the volatility of the portfolios and give clients greater peace of mind.
2. Government bonds
As market sentiment moved to "risk-off", demand surged for assets perceived as safe havens. Interest rate cuts also supported government bonds, although returns have been extremely volatile (the yield on the 10-year gilt moved between 0.1% and 1% during March), as all liquid assets have come under some pressure from investors looking to redeem.
Government bond yields have been low for a number of years, offering little investors little yield by way of compensation for their volatility and interest rate risk. Consequently, although the portfolios have had some exposure to government bonds, we have preferred to allocate to corporate bonds, which have offered investors a higher level of income. Corporate bonds underperformed government bonds during the sell-off but are now recovering.
Did you have exposure to gold?
We did not have a dedicated fund allocation to gold in our portfolios. In the past gold has been beneficial to portfolios at times of crisis, but that was not borne out on this occasion. One precious metals fund that we monitor (but did not hold) fell by 25% in the month of the sell-off and consequently, it would not have helped returns.
Have you bought or sold any funds?
We transitioned to remote working in March and have continued our investment process, with a particular focus on monitoring and reviewing our existing holdings. Although the majority of funds have performed better than / in line with our expectations, we anticipate a small number of funds will be changed. The changes we have made so far have been driven by alterations to asset allocation. We will communicate fund changes with you as they are implemented.
Will you sell funds that have underperformed?
We are reviewing every holding in our portfolios.
Performance is extremely important but needs to be considered especially carefully as the sell-off was characterised by a surge in investor demand for liquidity/cash. It is difficult to underestimate the impact this had, leading to severe dislocations in markets, especially in fixed income. Some problems seem to have been compounded by fixed income traders at the investment banks working remotely, which is particularly challenging in an asset class that trades over the counter. By way of example, at its peak, several fixed income managers reported that they were not able to find liquidity when selling US treasuries. This is absolutely without precedent.
Consequently, we need to look much more closely at funds to understand performance. Whilst lower quality assets proved to be completely illiquid, investors looking to redeem fixed income assets looked to high-quality bonds, especially shorter dated bonds, for which there were some buyers in the market - although this liquidity came at a price. As a result, some of the better quality bonds proved to be more volatile than investors would expect. Sterling investment grade bonds, which are a staple part of a lower risk portfolio, fell 13% during the March sell off - leading to much greater volatility for clients than we would like.
More recently we have seen liquidity begin to return to fixed income markets and as bonds have begun to recover, we have seen a stronger rebound from corporate bonds. It remains important for us to differentiate between volatility in bond prices due the recent liquidity issues and genuine underperformance, but we are hopeful that corporate bonds are regaining their footing and that investors will be rewarded going forward.
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