This document provides subscribers an up-to-date view on how products in general are responding to the COVID-19 induced correction. It includes a range of high level discussions such as market watchpoints and comments on all headline sectors. There are also performance snapshots for the period from 20 February to 16 March 2020 giving an early preview into the scope of the March numbers. Notably, Lonsec analysts are maintaining regular contact with fund managers and have heightened their surveillance during these volatile times.
Diversification worked well in the last week of February 2020 as equity markets sold off in response to the rapidly escalating COVID-19 pandemic. Bond markets, notably the highest quality and safest bonds (government bonds and high-quality investment grade credit) rose in price, providing a cushioning impact to multi-asset portfolios. Bonds, as expected, provided good diversification benefits in what was a typical ‘flight to quality’ episode.
Roll forward to March and we are now seeing a very different market – one that is evolving rapidly. Most notably, bond yields have been rising, meaning prices have been falling. What’s going on? Are bond markets looking through the current bad news and pricing in an economic recovery? Usually yields rally in response to positive economic news, don’t they? Unfortunately, this is not the case. Rising yields and falling equity markets are not a good combination for multi asset investors because it means correlations have risen.
10-year government bonds yields began rising rapidly in March
Source: Bloomberg, Lonsec
What we are seeing and hearing from our fund managers is that there are severe liquidity issues in bond markets. Our fixed income managers are reporting limited liquidity in what are usually the most liquid securities: government bonds. There are simply very few buyers of these assets and many sellers. Adding to the problem is the widening pipeline of bonds, with more supply on the way courtesy of government fiscal stimulus plans, which will be funded via new bond issuance. The impact of increased supply is, of course, to lower prices.
General deleveraging by investors is clearly taking place. Investors are selling any liquid assets they can – including bonds – to fund redemptions, margin calls, or simply to move into cash. Some of our fixed income managers have been taking profit, trimming their positions after building in additional duration to their portfolios in the second half of last year. Parts of the market are blaming hedge fund sellers (always the first and easiest to blame) and some are blaming social distancing, which is making it more difficult for bond traders to execute their trades working from home.
At the same time, we’ve seen companies drawing down their entire credit lines at banks in efforts to shore up their balance sheets and make it through the next few weeks, months, or quarters with little to no revenue coming in. Access to cash (or credit) is essential to keeping these businesses alive and through to the other side of this shutdown. Bills, interest payments and fixed costs still need to be serviced. Companies are hording cash, and those that held government bonds as part of their liquidity reserves are selling. The demand for liquidity has been great, and cash – or ‘cashflow’ – is certainly king in this environment.
In efforts to avoid a repeat of the global financial crisis, central banks are throwing everything they’ve got at this, flooding markets with liquidity to ensure credit markets continue to function and companies have access to funding. Stabilizing the government bond curve (off which all credit securities are priced) is a critical first step for a functioning credit market.
Here in Australia, the RBA announced a number of measures, including dropping the cash rate to 0.25%, providing strong forward guidance, introducing a term funding facility, and announcing its intention to buy government bonds across the curve to ensure the 3-year yield remains low at 0.25%. We expect a large buyer (with deep pockets) entering the market could go some way towards stabilizing bond yields. On the back of the RBA announcement, yields on the 3-year bond dropped from 0.62% to 0.35%. This is a good first step, however we will be monitoring markets closely to see if it is enough. Thankfully, we think the RBA still has more left in its arsenal if required.
Generally, we expect ETFs to trade close to their net asset value (NAV) due to the redemption mechanism that allows authorised participants to arbitrage between the ETF shares and the underlying shares.
However, in this recent period of heightened volatility and dislocation due to COVID-19, a number of ETFs have been trading at significant discounts, especially fixed income ETFs with large allocations to credit and high yield.
At the market’s close on 18 March, some of these discounts had narrowed to a small degree, but still ranged from -2% to -8%. The main issue is been the disruption to price discovery as credit markets have come under heightened stress, especially in the wake of the heavy falls in oil prices.
On the global equity ETF side, there has also been evidence of enhanced spreads immediately after US futures markets going into ‘limit down’ after breaching the -5% limit. The reason is that, due to time zone differences, market makers need to use futures markets as proxies when regional markets are closed and the ASX is open.
Without the S&P 500 futures markets to use as a proxy, market makers cannot effectively hedge their risk premia and need to use less-than-perfect proxies, exposing them to basis risk. This then narrows as regional markets open.
As a general observation, though, it’s fair to say that the local ETF market is holding up reasonably well in what has quickly turned into a severe market dislocation event. Markets such as these also shine a light on the golden rule for ETF liquidity, which is that the more liquid the underlying portfolio, the greater the efficacy of market making activities.
For example, cash and enhanced cash ETFs (such as BILL, AAA) are trading at NAV and have had basis point spreads, and large ASX ETFs have also been trading very well from a spread perspective. Importantly, while it is hard at present to gauge how long markets will stay volatile, the discounts and spread volatility should ease as markets normalise (whenever that might be).
The final point is that T+2 settlements for ETFs are very valuable in a ‘cash is king’ market such as this. This, along with the efficiency in implementing trades, has no doubt been behind the strong trading volumes we have seen, especially in larger ETFs.
Given the extraordinary movements we are all seeing in the market, we have decided to hold more frequent Investment Committee meetings and provide you with regular updates on our thoughts and discussions from a portfolio perspective.
Lonsec’s Investment Committees will now meet monthly, with additional meetings held as required, and we will send you a summary of our discussions to keep you up to date with the latest market and portfolio developments.
Our Investment Committees are comprised of our portfolio managers, heads of research, and external macro-economic experts. Our team utilises a combination of top-down and bottom-up analysis to establish our dynamic asset allocation positions. These will now be reviewed and updated at least monthly for our range of direct equity and manager portfolios (including our model portfolios and managed accounts).
Positioning leading into our March Investment Committee meetings
Leading into our most recent Investment Committee meetings in March, our overall active asset allocation positioning had a defensive bias. This included: a below target allocation to developed market equities; a positive tilt to emerging markets equities, real assets and alternatives; and a largely neutral allocation to fixed income assets.
The rationale for this positioning was based on our view that most asset classes were expensive – or at best fair value – while cyclical indicators were negative but improving, and the low interest rate environment was expected to continue. At the same time, the threat of ‘x factor’ events was ever-present, with geopolitical risks such as trade tensions between the US and China creating spikes in market volatility.
March Investment Committee discussion
One ‘x-factor’ few predicted three months ago was the COVID-19 virus (coronavirus), which has spread rapidly on a global scale. At the time of our March meeting, markets were heading into bear market territory (a drop of 20% or more) and market sentiment rapidly turned in anticipation of weak economic data in the coming quarters. Our in-house models showed valuations move towards fair value, but at the time of our meeting they had not yet reached ‘cheap’ territory.
Our base case was that we are likely to head into a mid-sized recession characterized by a market drop of around 30%. Committee members noted that, unlike the events of 2008, the banking system remained intact, but there was significant uncertainty about the duration of the virus, the possible flow-on effects throughout the economy, and the extent and efficacy of monetary and fiscal stimulus.
Asset allocation decision
The Committee decided to maintain the existing positioning with a view that markets had already pulled back and that there was still a high level of uncertainty in markets, which would result in high level of volatility.
We reviewed our positive tilt to emerging markets and decided to maintain the exposure. This was based on our view that it was one of the few asset classes that offered value leading into this environment, and that many emerging market economies had greater ability to stimulate via monetary or fiscal measures if required. While no changes were made, we recognized that at some point there will be an opportunity to take a more positive position into risk assets as valuations become more attractive.
Furthermore, we are monitoring liquidity in markets. We have observed liquidity dry up in some markets, particularly fixed income markets. The adoption of further quantitative easing by governments such as the US is aimed at providing such liquidity.
We believe that it is important to remain invested during periods such as this, but portfolio diversification is important. We will be looking to further diversify our portfolios from a bottom-up investment perspective.
We will continue to monitor the situation as the market environment is evolving quickly. From a portfolio governance perspective, we will be holding more frequent investment committee meetings, and there is provision to hold unscheduled meetings as required. We will be providing further updates over the coming weeks.
Find out more
For more information on the Investment Committee work that we do for the Lonsec Model and Managed Portfolios, as well as other external consulting clients, please contact us on 1300 826 395 or email@example.com. You can also find the latest insights via our website www.lonsec.com.au.
Sadly, the title of our Symposium now seems all too prophetic.
Following the advice of the Australian government and health authorities, we’ve decided that the best option is to cancel the event.
Over 900 people were already registered to attend, but we all need to help ‘flatten the curve’ and prevent the spread as much as we can.
At this stage we’re not planning to re-schedule, but we’re working to make the content available to everyone who registered. We’ll provide further information on how to access these materials as it becomes available.
Who knows, we may all have plenty of time at home to watch and read!
We’d like to thank our event sponsors, AllianceBernstein, Fidante, Fidelity, Investors Mutual, Legg Mason, Pendal Group, Schroders and Talaria, and we look forward to continuing to work with them to keep you informed.
Feel free to put the Lonsec Symposium 2021 (Thursday 29th April 2021) in your diaries, and we look forward to seeing you all there, if not before.
Lonsec Market & Portfolio Update: 17 March
Lonsec Market & Portfolio Update: 13 March
The COVID-19 virus has triggered a significant sell-off in markets and a spike in volatility. The VIX Index, which is a measure of forward-looking volatility for the S&P 500 Index, moved from around the 14% mark in mid-February to over 54% on 9 March, its highest point since the global financial crisis where the VIX reached above 70%. At the same time the oil price, as measured by the WTI Crude, started 2020 above the $63US mark has fallen below $40US per barrel on the back of an oil price war between Saudi Arabia and Russia.
Leading into the current market conditions, asset prices were viewed by Lonsec as trading at fair to expensive territory. The low interest rate environment continued to support risk assets and there were signs that some of the economic indicators that were trending down, such as global the PMI, stabilised and lowered the risk of a global recession. Roll forward to the current situation and asset class valuations have pulled back although they are not in ‘cheap’ territory. There is an expectation that economic indicators, many of which are lagging, are expected to be adversely impacted by the effect of the Covid-19 virus and market momentum has turned negative. From a policy perspective we have seen rate cuts in the US and the announcement of fiscal stimulus packages by governments around the globe, however the extent of any future stimulus is uncertain. What is also unclear is the length of time the virus will last, with the view being that the longer it lasts the greater the chance of a recession.
From a Lonsec perspective, based on the information we currently have, we think that growth is likely to slow and a mid-level recession is possible should the length of the virus extend into the months ahead and fiscal stimulus is insufficient to alleviate any downturn, Unlike 2008 the banking sector remains intact however any downturn will likely be driven by supply and demand side pressures.
Our overall asset allocation positioning retains a slight defensive bias. We believe that at some stage there will be an opportunity to take a more positive tilt into growth assets however in a period of uncertainty our focus is on further diversifying our portfolios with assets and investment strategies that offer diversification.
How are we positioning our portfolios?
- The Lonsec Multi-Asset and Listed Managed Portfolios were cautiously positioned leading into the new year. From a Dynamic Asset Allocation (DAA) perspective, we were slightly underweight both Australian and global equities in favour of real assets and alternatives (within the Multi-asset portfolios). The Retirement Managed Portfolios have also been positioned with some more defensive strategies incorporated within the portfolio to provide cushioning in a market downturn.While we had no way of predicting the emergence or extent of the Coronavirus, we viewed equity valuations as being stretched and therefore vulnerable to any potential shocks to, what we saw as, an overly optimistic growth outlook. The speed and severity at which equity markets have responded to the outbreak over the last few weeks has surprised many, including ourselves. In a typical ‘flight to quality’ episode, traditional defensive assets such as government bonds performed well, offsetting some of the losses inflicted by the aggressive sell-off in risk assets such as equities and high yield bonds.
- Against this backdrop, the Lonsec Multi-Asset portfolios outperformed their respective benchmarks over the month of February (with the exception of the Conservative portfolio which was marginally under its benchmark for the month). The Listed portfolios tracked the markets given the higher exposure to market beta, given the portfolio invest solely in listed investments including passive ETFs.
- Our Australian equity managers performed well, notably those with a strong risk management focus. AB Managed Volatility Equities Fund and Pengana Australian Equities Fund both significantly outperformed the benchmark. Allan Gray Australia Equity Fund was however a clear underperformer, with its deep value contrarian investment style struggling in this environment. Global equity managers performed largely as expected, with Antipodes Global Fund providing good risk control by design. Our unhedged global equity exposures also benefited the portfolios with the falling AUD cushioning the extent of losses within our global equity portfolio. Overall our equity managers have adopted a more defensive positioning in recent weeks. Where they have the flexibility, they have been increasing their cash holdings and reducing exposures to sectors impacted most heavily by the Coronavirus.
- Our preference for ‘defensive’ fixed income assets has also benefited the portfolio with government bonds and high-quality corporates outperforming high yield credit. Our fixed managers have been adding duration in recent months which has provided good risk-off diversification benefits at the portfolio level. Our alternatives managers produced mixed results. CFM Institutional Systematic Diversified Trust was a clear detractor from performance, with all underlying sub-strategies unexpectedly delivering losses in February.
- Looking forward, we have maintained our defensive positioning and are looking to further diversify the portfolios at higher risk profiles. We remain slightly underweight both Australian and global equities in favour of real assets and alternatives. We favour Global REITS and Global Listed Infrastructure where we see better value and believe they will continue to be beneficiaries of a low interest rate environment. Within global equities we maintain a preference for emerging markets over developed market on the basis that emerging market central banks and governments have far greater capacity to respond to any extended downturn through both monetary and fiscal policy. Developed market central banks on the other hand, are low on firepower meaning governments will be left to pick up the slack with more co-ordinated fiscal spending.
- While we have little clarity on how long the impact of the Coronavirus outbreak will last, we do expect volatility to continue and seek to manage risk through the multiple levers available to us; active asset allocation, lowly correlated return sources (including alternatives and traditional diversifiers such as government bonds) and by investing in high-quality managers. We expect central bank and fiscal support to be forthcoming which should provide much needed support for global economies and help steady markets. That said, the outlook remains uncertain. Our portfolios remain very liquid which puts us in good position to take advantage of opportunities should conditions improve.
The coronavirus has had a major impact on equity markets in the past few days, and the uncertainty surrounding looks set to continue for some time. Peter Green, our Head of Listed Products, looks at the stocks that have been directly and indirectly affected, as well as some of the reporting season’s best and worst performers.
It has been a turbulent start to the year with Australia beginning the recovery process from the tragic bushfires followed by the threat of a global pandemic with cases of the coronavirus increasing across the globe. Despite these events markets did not flinch in January, with equity markets generating strong returns for the month as liquidity conditions continue to be supportive of markets.
If we look at previous incidents of viral outbreaks, such as SARS in 2003 and H1N1 (swine flu) in 2009, short-term corrections were within the range of 5% to 15%. These corrections were followed by strong rebounds. The consensus view is that global growth will be down in the first quarter of the year as a result of the coronavirus with the key variable being how long the threat of the virus persists.
While history is a useful guide in this case, it must be said that the effect of this epidemic is likely to be greater given China’s dominant presence in the global economy, given the faster spread of the disease and the measures taken to combat it. The extended closure of Chinese industry, restrictions on people movement, disrupted supply chains, declines in key commodity prices, bans on Chinese travel and the flow-on effect to confidence will severely hamper growth in China and the countries and regions most heavily reliant on China.
While at the time of the SARS outbreak China accounted for around 9.0% of global output on a PPP basis, it now accounts for 19%, and this proportion is only likely to increase in coming years, according to the IMF. China accounts for 18% of global tourism spending (up from 4.0% in 2008) while overall tourism (domestic and global) spending accounts for more than 10.0% of Chinese GDP and has been contributing almost 1.5% to annual GDP growth. To place China’s emergence on the global stage into perspective, in 2003 there were 20 million Chinese overseas visits and in 2018, 150 million. The Chinese economy accounted for about 30% of global growth in 2019. So a drop in Chinese GDP growth to 5.0% for the year, assuming the virus is contained within a short period, would detract 0.2–0.3% from global growth.
China now accounts for around 19% of global output
Source: IMF, Lonsec
From an Australian equities perspective, we are likely to see earnings outlook downgrades across a number of sectors, at a time of elevated valuations and a sub-par growth outlook. While earnings across the Healthcare, Consumer Staples and Infrastructure sectors should be relatively immune to recent events, based on Lonsec’s initial estimates, 2020 earnings estimates for the Resources (Energy, Iron Ore and Copper), Tourism/Travel and Consumer Discretionary sectors are likely to see significant one-off earnings revisions, capturing the impact of the coronavirus outbreak and the recent bushfires across Australia. However, such downgrades are unlikely to impact the long-term investment thesis for most companies and should be regarded as short-term headwinds, reflecting a series of one-off unfortunate events.
From an asset allocation perspective, Lonsec’s multi-asset portfolios remain very well diversified with only a small direct exposure to Chinese equity and bond markets. Consequently, our current focus is on the flow on effects that a sustained slowdown in Chinese growth may have on the domestic growth outlook given our close trading ties. As previously noted, our valuation indicators for Australian equities remain elevated, making them susceptible to a pullback should Chinese authorities’ attempts to stabilise growth fail. We have maintained our slight underweight positions in both global and Australian equities for the time being, however continue to monitor events closely.
While there is a high degree of uncertainty regarding the coronavirus outbreak, Lonsec notes that this event does pose a long “tail risk” for global markets should the outbreak get out of hand. These factors make it a challenging period for investors, where factors other than fundamentals are having a material impact on the trajectory of markets. In such an environment, we believe selective valuation opportunities will present themselves for long-term investors, however ensuring that your portfolio is diversified will be very important in navigating an increasingly volatile market environment.
Although the secrets of a long life remain a mystery, there are now over 300,000 centenarians across the globe and the numbers are rising. Most of us will not survive to 100 no matter how many green vegetables we eat, but there is no doubt life expectancy is increasing. In Japan, 2.5 times more adult than baby diapers are sold. Australian life expectancy from birth is among the highest in the world with the average man living to 80.7 and 84.9 for a woman. It assumes no improvement in healthcare which can increase life expectancy further.