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Multi-Asset Strategist Adam Berger has received a wide range of questions from asset allocators in recent weeks. Drawing on his research and insights from others around our firm, he tackles 10 of them below. (See Adam’s latest Top of Mind publication, with more on the crisis, here.)
1. When the rebound from this crisis comes, will it follow a trajectory similar to previous rebounds?
Before this crisis hit, I was worried (more generally) that the next crisis would be more U-shaped (like 2000 – 2002) rather than V-shaped (like 2008). But given that this crisis is driven by a discrete event (albeit a drawn-out one), I think the market will rebound quickly once it is behind us. Perhaps not all the way to previous highs (especially in the US, where valuations were rich coming into the crisis), but meaningfully above current levels. If there are second or third waves of the disease, we may still see more waves of panic and more big drops along the way — but I think the recovery will look broadly like past V-shaped rebounds.
2. What are your three leading indicators that the bottom has been reached?
- Signs that the worst news on the medical/health front is behind us (in many countries, this may be the moment a national lockdown is declared)
- An increase in implied volatility further out on the curve (e.g., one-year or two-year volatility, rather than the one-month VIX that is widely quoted) — a sign that investors have capitulated and expect volatility to persist
- A positive turn in momentum, suggesting the worst is behind us
3. Is some of the market volatility associated with ETF trading?
I asked our derivatives strategist, Gordy Lawrence, for his opinion on this question. He thinks there’s a good chance that the trading patterns of leveraged and inverse (short) ETFs are exacerbating daily moves. Effectively, to stay properly exposed, these funds need to trade each day in the same direction the market is moving, and the size of the trade is proportional to the move in the market. In addition, fixed income ETFs have become a much larger part of the market since the global financial crisis (GFC), and particularly over the last three years. The structure of the fixed income ETFs is similar to equity ETFs, but because the corporate-bond universe is so vast and illiquid, the arbitrage process — particularly in times of stress — is far more complicated. In a normal market, this process typically works well and can actually add liquidity to the market because you have a new price-maker involved. But in the current crisis, because there have effectively been forced sellers of fixed income ETFs, that spread has become wider and wider.
4. What can an asset allocator do during times of such volatility and illiquidity?
It depends on the allocator. For most, the best course may be to stick with the long-term policy their organization set up and rebalance as appropriate to maintain it. Once things have settled down, there will be opportunities to revisit policy in light of changing market dynamics (e.g., long-term capital market assumptions) and perhaps new information about the portfolio’s risk constraints or return objective. For others, periods of volatility and illiquidity create opportunities to enhance returns by providing liquidity to markets and being a buyer when many other market participants are sellers. Doing this requires a strong governance process; ideally, the wheels for this type of structure are set in motion well before a crisis occurs.
5. How do you think about small-cap equities today?
Small caps have traditionally had a high beta to the market. This crisis has clearly hurt them on the way down, but may be expected to help them on the way back up. However, small caps have also underperformed large caps in the US over a longer period — and although I expect that to normalize in the longer term, I’m a bit more cautious about the next year or two. I’m also worried that the economic slowdown in the US in the wake of the crisis could hurt small caps more than large caps, and while I expect government intervention to help, I’m not sure how much it will help small caps specifically. Having said all that, I do like the alpha potential in small caps, which is another potential tailwind on the upside.
6. Credit spreads across high-yield and investment-grade markets have widened considerably. Do you think this appropriately reflects default risk or is there still room for widening?
I think the widening in high-yield and investment-grade spreads has overshot and is pricing in a degree of defaults that is unlikely to be realized going forward (the combination of a panic and a liquidity shortage will do that). While I think prices are attractive, I also have to acknowledge that there is room to widen from here: perhaps from the fundamentals worsening if the impending downturn starts to look more severe or perhaps from investor sentiment souring further if the course of COVID-19 is worse than people expect. (There is also a risk that both markets feel the strain of companies being downgraded from investment-grade to high-yield.) I do not believe we will come close to retesting the 2008 GFC lows, which reflected the possibility of a near-collapse in the financial system. As a result, this could potentially be a good buying opportunity for investors with a three- to five-year horizon.
7. What is your forecast for the US dollar vs major currencies?
I asked a few of our currency experts for their opinions. During the past few weeks, the US-dollar trade-weighted index has made new highs amid a scramble for US-dollar liquidity. As we look forward, we expect the US dollar could start to be judged by more traditional fundamental drivers of currencies. The Fed has cut interest rates to zero, real yields are now negative across the curve, and the Fed is injecting US-dollar liquidity into the market at a rate that is multiples higher than what we saw during the GFC. Traditional economics would tell you these factors should lead to general depreciation of the US dollar. However, we are still dealing with a public health crisis globally, markets are still volatile, and the US dollar maintains its status as the global funding currency and a safe haven, which could continue to provide near-term support. Having said that, we are also cognizant of the speed and magnitude of the US dollar’s recent appreciation. Hence, we are watching for any signs of a pause or short-term reversal in the broad US-dollar index that may be led by higher-beta G10 currencies given their recent rapid decline.
8. What will it take for emerging markets to outperform again?
Emerging markets entered the crisis with attractive valuations relative to other global equity markets, so I think a global recovery from the current crisis should provide a healthy tailwind. China represents a large weight in the index, so continued growth in China could be an important driver. Note that for the markets to perform, we need earnings to grow, so that means the question is less about GDP and more about corporate earnings. And there is some evidence that slowing economic growth in China (driven not by the current crisis, but more by the long-term trend) could actually help stocks. (Faster-growing economies sometimes generate lower returns because growth requires raising equity capital, which tends to reduce returns.) Finally, if inflation is largely off the table as a risk in many emerging markets, that could give central banks leeway to stimulate these economies further. The big risks here are that some emerging markets may have fewer resources to combat COVID-19 infections and that the disease may not yet have hit these countries in a meaningful way.
9. Is globalization dead or at least in decline?
I don’t think globalization is dead and I’m not even sure it’s in decline. It’s too early to say. For much of the world, the benefits of globalization should outweigh the costs. There may be a different path forward, where countries revisit what industries they want to maintain/protect domestically and where they want to encourage imports, but I think global trade will survive and even grow. There may be more country-to-country trade conflicts, and perhaps even an escalation in US-China tensions. I can even imagine a new version of the Cold War, with close alliances on each side (although that’s not my base case). But even in this scenario, I believe countries will trade with each other and benefit from their relative competitive advantages. I would emphasize that this is my opinion — many others take the opposite side of this call (see, for example, this view from Macro Strategist John Butler).
10. ESG/impact strategies tend to be underweight energy and overweight information technology and health care. Could this crisis create an opening for ESG strategies in institutional portfolios?
I asked Wendy Cromwell, Wellington’s director of Sustainable Investment, for her opinion, and she thinks so. Some institutional investors still feel that ESG or impact strategies invest in a concessionary manner, even though we have found that analyzing a company holistically can lead to differentiated insights. To the point on structural underweights to energy and overweights to information technology and health care, we see this in impact strategies due to the focus on companies whose goods and services address a pressing world problem. Indeed, this may turn out to add substantial alpha potential. On a related note, we could see an accelerated energy transition. Three things we’re currently observing: 1) there doesn’t appear to be much political support for the fossil fuel industry in the US; 2) the concept of divestment has moved from cynical to a concrete conversation; 3) carbon footprinting of portfolios is accelerating. We saw a rise in capital allocators’ interest in the sustainability space in recent years, and, if anything, that has accelerated since the coronavirus outbreak, as it seems stakeholders are more interested in understanding how companies are responding to this crisis across E, S, and G.