No one really has any superior knowledge or insights into the impact of Covid-19. Everyone in these tumultuous times operates on imperfect information when assessing the impact of the virus.
What we do know however is that things are likely to get worse before they get better. China’s recent manufacturing and demand slump will likely affect activity in the rest of the world with a lag of a few months. In addition, the demand for services, including travel, tourism, events, entertainment and restaurant meals, are likely to contract due to containment measures that are in place or in the process of being implemented across a number of regions and countries.
The fluidity of the situation can be seen in the data being reported by various governments on infection and mortality rates, as well as fear on the part of investors, spread largely by the media. The reaction of global markets and the changing forecasts and outlooks from global banks are also a moving target.
What’s important to note is that the current episode emanates from an external shock or event. In this respect, the situation we find ourselves in is different from the financial crisis of 2008, which was a systemic event. In a sense, the current episode is more similar to 9/11. However, it is possible that the wider impact of the virus leads to something more systemic. The market has already priced in the extent to which the exponential proliferation of Covid-19 increases the probability of a regional and/or global recession.
The bottom line however is that the ultimate impact is unknown and we believe it would be hazardous to make point estimates at this stage. Instead, we think it is more useful to ensure that our portfolios are appropriately positioned for their given risk profiles to allow us to weather periods of heightened volatility such as we are seeing at the moment.
Volatility reaches a record high
Europe has become the epicentre of the global pandemic with a number of countries closing their borders and effectively putting large parts (if not all) of their population under quarantine, while others – including South Africa – have declared the outbreak a national emergency. The speed at which the market has corrected has been truly staggering, with the S&P 500 falling by its largest daily drawdown since Black Monday in 1987, on two separate occasions in the past month. Yet in between these two days it also recorded its largest daily gain since 2009. Given these wild swings it is no surprise that the VIX has also recorded its highest closing level on record – even higher than during 2008.
We had expected policy responses from central banks and governments and it was the central banks that delivered first, at least those in a position to do so, by easing monetary policy in an effort to prevent a further tightening of financial conditions. Investors have in particular been watching the US Federal Reserve. With even the US Treasury market showing signs of illiquidity and poor functioning, the Fed delivered an extraordinary amount of liquidity via repo facilities, to ensure the proper functioning of arguably the most important market in the world – the US Treasury market and the funding channels that rely on these securities as collateral. This has now been extended to include various programmes to support the effective functioning of markets while aiming to provide funding where it is needed. While these actions may have alleviated any immediate pressures in funding markets, we need to see that this has indeed been effective as time progresses.
More significant yet was the Fed announcement of a 100bps decrease in the Federal Funds Rate to 0-0.25% and a return to the crisis era effective lower bound for US interest rates, thereby exhausting their most conventional policy tool. In addition, an asset purchase programme which is effectively open-ended, has been rolled out that will see the Fed extend its current asset purchase program beyond bills and will now include coupon securities across the curve as well as agency mortgage-backed securities, corporate bonds and ETFs.
Initial market reactions suggested a broad disappointment with the level of monetary policy intervention but with the baton passed firmly on to governments, we have since seen an unprecedented level of fiscal stimulus measures being planned and delivered. The UK government has already moved to provide £350 billion to support businesses and households during the crisis. Across the pond, the US Senate appear to have brushed aside their differences with the imminent approval of an approximately $2 trillion stimulus package in response to the pandemic. The bill, the largest of its kind in modern American history, is also aimed at providing support to struggling business and households, as well as providing additional and critical support to hospitals.
It is of course too early to determine if these measures will follow through and have a lasting and meaningful impact that is consistent with their intentions, however markets are all about expectations and market reaction has so far been broadly positive.
What should investors bear in mind?
It’s important that investors keep a few things in mind in the context of the current market volatility:
- Now is not the time to panic. In times of extreme market volatility, it is important to stick to your investment strategy. Selling on extended weakness is not a winning strategy over the longer term.
- We do not think it is appropriate to make significant portfolio changes at present – with heightened volatility, it is easy to get this wrong. Liquidity may also be limited, potentially compounding mistakes when trying to make significant changes to a portfolio. A recent comment from Goldman Sachs’ Investment Strategy Group made this point very well, “when the market is generating a typical year’s worth of gains or losses in a single day, the penalty of trading missteps is high.” Changes to portfolios should not be made to try and time the market in an effort to generate outsized absolute or relative returns but rather to rebalance portfolios to an appropriate asset allocation.
- As unattractive as high-quality global fixed income assets may appear from a valuation or yield perspective, they still warrant a place in a diversified multi-asset portfolio. Fixed income is the one asset class that has consistently proven to provide negative correlation (and therefore something of an offsetting effect, or ballast) to equities or other risk assets.
In conclusion, as with any material event that impacts markets, there is a beginning, a middle and an end – it is important to remember that this too will come to an end at some point. The timing is uncertain but that reinforces the need for a longer-term time horizon. Some markets are likely to be oversold in the short term but this does not necessarily mean we have reached the end of the current episode.
Paul Wiseman, is a senior investment manager and James Newell is a senior investment manager at Maitland.