Deaths from coronavirus (Covid-19) stand at 2,858 – a tragic loss of life but dwarfed by historic pandemics. Before this week, the positive narrative that buoyed risk assets was predicated on the absence of sustained outbreaks outside of China, but on the back of a surge in Italy (647 cases as of 28 February) and South Korea (2,337), shares have sold off strongly and a flight to quality is illustrated by the yield on 10-year US treasuries falling to just under 1.2 per cent.
Dashed hopes of a rapid geographical containment have prompted re-ratings of global stock markets, on the realisation that the economic impact of the virus will likely be severe. Matthew Cady, investment strategist at Brooks MacDonald, stresses that, in 2018, China accounted for proportionately four times more of global GDP than it did during the Sars outbreak in 2002-03, which knocked around 0.1 per cent off world growth. He says: “With the greater integration of global just-in-time supply chains, business disruption can travel just as fast as any virus.”
Portfolio diversification cushions the blow
Circumspect asset allocation is proving its worth in the current turmoil. Investors Chronicle’s Tactical Asset Allocation (TAA) portfolio has delivered a flat total returns performance of 0.3 per cent since it was rebalanced in December 2019, compared with a 3.3 per cent loss for a 60:40 split of FTSE 100 stocks and UK government bonds. Just investing in the UK blue-chip index via an exchange traded fund (ETF) would have lost 5.7 per cent.
Developed equity markets have taken a hammering, largely because the economic disruption to supply chains and travel will damage profit outlooks. Companies are on such stretched multiples that re-rating of valuations was inevitable. In the UK, the concentration of the FTSE 100 in oil & gas majors and miners, who are exposed to falling commodity prices, and the fact other sizeable industrials and consumer discretionary stocks have significant Asia exposure, is increasing the probability of earnings downgrades.
The FTSE 100 isn’t the worst performing asset in our portfolio, the ETF we use to track Japan is down 8.2 per cent, but the losses on equity indices are offset by gains in other asset classes. Notably, our gold ETF is up 11.8 per cent, reflecting the rush for haven assets. The yellow metal is trading around $1,650 per oz and analysts Wayne Gordon and Giovanni Staunovo at UBS Global Wealth Management see it going above $1,700 or even $1,800/oz if Covid-19 becomes a pandemic.
Putting yourself at the heart of the allocation decision
Our TAA was quite aggressive – overall it holds 65 per cent equity – so the fact it has held up is testimony to the value of diversification. The decision for investors is whether to remain positioned for a strong recovery or batten down the hatches for a meltdown. As ever, this depends on personal circumstances and stomach for big dips in portfolio value.
More conservative allocation is required for investors who think the situation could worsen. As well as gold’s stellar performance, our portfolio has made gains from real estate and high-yield bonds, which are asset classes that haven’t come under sustained pressure, but sentiment has changed in recent days. It will be interesting to watch how the spread in yields between corporate bonds and safer sovereign debt develops.
The outlook for real estate and fixed income is discussed by investment manager Nuveen (which as of 30 September 2019 had more than $1 trillion under management). Its chief investment strategist, Brian Nick, writes that “U.S. corporate credit spreads came into this period close to all-time tight levels, which reflected too much complacency about the virus’ impact in addition to moderating signals around global growth”. Despite this, Mr Nick goes on to explain: “Given the still-supportive fundamentals and technicals for fixed income assets, we are looking to exploit recent volatility to selectively add risk in portfolios.” On real estate, Nuveen is working on the base case that the greatest effect will be felt in the Asia Pacific region and sums up that “overall, commercial real estate remains an appealing risk mitigator for many investors”.
Pessimists will still want to keep an eye on the credit markets, however. The outlook for falling interest rates may be the prime factor for bond prices, but should prolonged economic weakness precipitate more companies missing covenants, or even failing to keep up with their obligations, asset managers may become less sanguine. Earnings disappointments are now being priced in by equity markets but, arguably, the risk of defaults is not.
