This Too Shall Pass
The COVID-19 pandemic is a shock without precedent in modern times. So too is the policy response.
Amid this ﬂuid environment, David Wolf and David Tulk, Portfolio Managers with Fidelity Investments, discuss below what they know, what they think, and what they’re doing with the multi asset class funds they manage.
We know that an unprecedented shock has been met with an unprecedented policy response
We think value is emerging in equities, but patience is warranted
We are positioning the funds for protection in the short-term and out-performance in the long-term
What we know
We know that market volatility has become extreme (see Exhibit 1).
The S&P 500 fell 20% in the ﬁrst quarter despite a late-March bounce; the decline in Canadian equities was larger still, rivaling the worst drops of the past century.
The shock has extended to the ﬁxed income markets, where the prices of corporate credit instruments have fallen sharply despite lower policy interest rates and government bond yields.
We know that the chaotic declines in the prices of virtually all assets reﬂect at least three things.
One, the inevitable massive shock to the economy, which the data are only starting to reveal as we write (see Exhibit 2).
This will challenge not only the earnings but in some cases the solvency of companies.
Two, the uncertainty surrounding just how large and long-lasting that shock will be.
And three, the illiquidity of markets, as investors scramble for cash through a door narrowed by regulation and fear.
We also know that the policy response is massive and growing. The ﬁscal, monetary and regulatory ’bazookas’ are all being been ﬁred in a bid to stabilize markets and ﬁll in the economic crater.
The actions of the US Federal Reserve have been particularly important, given the central role of US dollar liquidity in the global ﬁnancial system, with the central bank effectively making an open-ended commitment to inject cash by buying securities in unprecedented scope and size (see Exhibit 3).
Other central banks have followed suit, including the Bank of Canada, which has initiated the quantitative easing program it managed to avoid in 2008. Regulators in Canada and elsewhere have eased restrictions on banks to ensure that these liquidity measures allow credit to ﬂow where it’s needed.
And the ﬁscal response has arguably been the most breathtaking, as governments pour out cash to families and businesses that have seen their incomes disappear, deﬁcits be damned.
What we think
We think COVID-19 will remain a global issue for an extended period of time. Our research network, encompassing both Fidelity’s health care analysts and outside experts, advises us that the virus will likely remain a threat until either an effective treatment or vaccine is produced or ’herd immunity’ is reached. That may not happen for many months.
Authorities are employing the strategy of ’mitigation’, enforcing restrictions and quarantines to ’ﬂatten the curve’ so as to not overwhelm the health care system. But there is a tension here: the more the authorities try to diminish the human cost by shutting everything down, the greater the economic cost (which itself takes a clear human toll). The balance that will need to be struck between the two going forward, and thus the aggregate toll taken by the virus, remains uncertain.
We think that the persistence of the virus does not, however, mean the persistence of economic and market declines. Both have taken a big hit. But, as above, economic policy-makers are adopting a ’whatever it takes’ approach.
We think that this support will ultimately help mitigate the sources of market pressure described above – the hit to the economy, the uncertainty surrounding it and the illiquidity of markets. It will take time and will not be a linear process. But we do expect it to show the scaremongering about another ’Great Depression’ to have been misplaced.
We also think that the economic, ﬁnancial and policy turbulence caused by the COVID-19 pandemic and its effects will hasten a number of the longer-term macro issues we’ve been focused on. Two in particular:
One, we think inﬂation will eventually be coming. We have long been concerned about the potential erosion of central bank independence. That process may now be unfolding before our eyes.
The wartime footing being adopted by policy-makers doesn’t allow for peacetime luxuries like ﬁne-tuning ﬁnancial conditions to hit inﬂation targets. It may seem silly to fret about inﬂation when faced with a clear and present deﬂationary shock. But when the shock passes, we will be left with super-stimulative monetary and ﬁscal settings that policy-makers will likely be unwilling or unable to take back.
We will also likely be left with a further de-globalized world economy that is less efﬁcient and thus more costly. Inﬂation may well be seen as the path of least resistance in addressing the further ballooning of government debt and impairment of growth created by the crisis and its response.
Two, we think that Canada faces particular challenges here. Canada is a small, open, commodity- producing economy upon which global shocks always have disproportionately large effects.
Canada’s economy came into this crisis with signiﬁcant imbalances, over-reliant on household spending and debt; recessions are always deeper when there are excesses to be worked off.
Three, Canada remains reliant on the energy sector, where the supply/demand dynamics that have driven oil prices to generational lows pose a severe challenge to the industry.
Four, Canada’s economic growth in recent years has owed entirely to immigration-driven population growth, which has now ceased.
And ﬁve, Canada’s climate is cold and its population is concentrated, which may imply a greater challenge from the virus itself.
What we’re doing
First and foremost, we are fulﬁlling our essential job of being good stewards of the funds in our capacity as ﬁduciaries. That means focusing on the safety and soundness of our investments, fulﬁlling our unwavering commitment to daily liquidity, and avoiding selling securities at bad prices that would lead to permanent impairment of the value of the portfolios.
We are re-balancing opportunistically, shifting into risky assets at a measured pace as bond market liquidity becomes available and the equity market searches for a bottom. Our re-balancing approach is an element of our broader active asset allocation process, informed by our dedicated asset allocation research as well as our collaboration with the managers of our equity and ﬁxed income building blocks.
Those inputs suggest only a gradual shift back into risky assets. The goal is to steadily accumulate cheap assets that will lead to out-performance in the funds over the longer-term horizon on which we remain focused.
We are, to be sure, seeing value emerge in equities. From a bottom-up perspective, our managers are seeing better opportunities to buy good businesses at cheap prices, including some of our long-skeptical managers who are now fully invested. From a top-down perspective, the equity risk premium that can be collected – the relative cheapness of equities – is now back up at generational highs (see Exhibit 4).
However, the stock market lows may not yet be in. The downgrades to forecasts by economists and equity analysts look woefully inadequate thus far.
The uncertainty surrounding those estimates and the broader outlook cannot be expected to fade soon.
And we are not going to fund equity purchases by selling bonds into distressed markets at the adverse prices our ﬁxed income colleagues tell us they would fetch.
We are also adjusting the proﬁle of our portfolio allocations as we make the shift back into equities. As noted above, we think higher and more volatile inﬂation is a plausible long-term outcome here, one that markets have clearly not priced in.
Among other things, this would mean a move to appreciably negative real interest rates (given the likelihood of ﬁnancial repression manifested in effective caps on nominal rates) and a less-negative correlation between stocks and bonds (given that inﬂation shocks, unlike growth shocks, tend to affect both asset classes in the same direction). As a result, we are further tilting the defensive elements of our portfolios away from nominal bonds towards inﬂation-protected bonds and gold.
We are furthermore increasing our diversiﬁcation from Canadian into global assets. As above, we are concerned about the particular challenges Canada faces in this environment. But more broadly, it remains the case that going global offers greater market breadth and depth as well as a wider set of opportunities, with unhedged exposure bringing the added beneﬁt of reducing volatility through counter-cyclical currency exposure.
In fact, it is hard to imagine a better demonstration than the current episode of the value of diversiﬁcation into global assets speciﬁcally and across asset classes more broadly.
Looking over a longer period, since we moved to active asset allocation in late 2013, investors have earned a total return of 49% in the Global Balanced FMP even with recent losses incurred through the end of March – roughly double the return on the generic Canadian 60/40 portfolio (see Exhibit 5).
Let us conclude with another thing we know: this too shall pass.
Our unwavering focus in the meantime is to protect the portfolios as the crisis plays out while positioning them for out-performance when this does, indeed, pass.