March 19, 2020
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
To view and download a PDF of this commentary, click here.
As markets and conditions continue to evolve, we wanted to update our clients on three of the topics we’re thinking about:
Where Are We at in This Current Environment?
When we first heard of COVID-19 (Coronavirus) several months ago, no one could have predicted the measures that have been taken to date. As the virus spreads throughout the world, necessary precautions are being taken to limit the spread of the disease and to prevent overwhelming the health care system. Most people are either working from home or not working, practicing social distancing, and waiting daily for new news on what’s next.
No one predicted a global pandemic would cause the next recession, but it has. Make no mistake, we fully expect GDP growth to be negative for at least one to two quarters. UCLA’s economic forecast predicts 2nd quarter GDP to be -6.5%, and third quarter to be -1.9%, with a rebound in the fourth quarter. Markets are struggling to find footing without enough information to know how long social distancing will continue or what will be the catalyst to bring revenue growth back. While some businesses will weather the storm and make up for it on the other end, others, like restaurants, will permanently lose revenue and may not survive.
We are seeing volatility in equity markets that we expect will continue for several months, if not longer. That does not mean markets will keep declining (they may), but we are likely to be down 25-50% from the highs for some time. News will continue to drive markets up and down, so investors should expect continuing significant volatility.
While it may feel like 2008, there are material differences to consider. First, from a financial system perspective, banks and financial institutions are much healthier than they were in 2008. The financial crisis put into question the solvency of banks on a global scale, which is not something we’re dealing with currently. Banks are healthy and the Federal Reserve is taking multiple steps to ensure capital markets continue to operate. Second, governments are acting quickly to provide support. In the U.S. and across the world, fiscal packages are being proposed to support those who need help through this difficult time. Actions that limit the impact of decreased demand on the economy will help recovery happen more quickly.
Markets are looking for information that puts a timeline on reduced demand. That could come in many forms: a specific date when social distancing will end, a treatment for those infected with COVID-19, or a timeline on when a vaccine will be available. Any and all of these will be welcomed news for markets and will help company executives forecast future earnings, but it doesn’t necessarily mean the market has hit bottom. There are ripple effects occurring even now that will need to play out before markets will recover including defaults on corporate bonds, an increase in unemployment, and demand recovery.
We share this to help our clients and readers prepare for what’s to come. We hit the peak of the market on February 19th. In less than a month, global equity markets are down 25-35% (depending on the day). We experienced the fastest path to a bear market in history, but we do not expect the recovery to be V shaped. Investors should be prepared for six to nine months of a challenging market environment, but we will recover. The light at the end of the tunnel is more visible in this environment than it was in 2008, but it’s still a ways off.
How Are Portfolios Doing?
When looking at portfolios, investors should expect their equity allocations to track global equity markets. There is very little discrimination in the selling that is occurring; everything is going down. For our clients, we hope the risk tolerance we discussed prior to creating portfolios was appropriate. All client portfolios are negative, but the magnitude of loss has a lot to do with how much equity is in the portfolio. If losses are greater than anticipated or are causing extreme discomfort, we encourage investors not to make decisions in this moment. Call a member of your engagement team and discuss how you’re feeling; but now is not the time to change your asset allocation. In 2008, client portfolios returned to previous highs in approximately 18 months. Being patient will reap massive rewards, and when portfolios have recovered, investors can reconsider the appropriate asset allocation.
Fortunately for MRA clients, many non-equity positions are holding up well in the crisis. Our fixed-income allocations are a mix of traditional bond mutual funds, municipal bond separate accounts, and private debt. Decisions we made several years ago regarding how we allocate fixed income are benefiting us today. For traditional fixed income in bond mutual funds, we focused on high-quality managers with very large funds. Bond markets today are experiencing a lot of volatility as investors seek cash, and managers with smaller or more aggressive funds are being forced to sell high-quality assets at a discount, which will materially impact future returns. The municipal bond market is seeing the same volatility, as investors are selling their high-quality assets for cash so they can avoid taking a big discount on lower-quality investments. Using a separate account for municipal bonds immunizes us from that risk. We decide when to sell and can’t be forced to find liquidity. None of the volatility in the municipal market is due to credit concerns, so we remain very confident in the quality of our liquid fixed income positions.
Within private debt, we are also avoiding forced selling of assets. While the underlying loans may adjust their price based on the current environment, these are temporary marks, similar to a stock trading lower but not realizing the price unless it’s sold. We have spoken directly to every single private debt manager with whom we work. They all experienced 2008 when credit concerns were a much bigger issue. At present, they all remain confident in the composition of their portfolios and their ability to manage through this crisis. We expect the value of positions to decline slightly, but it would be temporary, and the positions should recover lost value post-crisis. In short, our fixed income is providing meaningful downside protection from equities while avoiding many of the challenges playing out in the broader fixed income market.
For clients that own our non-traditional strategies, these are also holding up quite well. Our commercial real estate position is comprised of private real estate, so it is not fluctuating as dramatically as publicly-traded REITs. We do expect to see some decline in value, but not nearly as much as REITs, which are trading with the equity market. Reinsurance remains stable, as its performance is driven by weather events and not economic events. As we’ve discussed with many clients, even if there were material events that affected the portfolio later this year, premiums are at a level that we would still expect a mid-single digit return, which could provide great stability if equity markets remain challenged throughout the year. Life settlements is unaffected by the current situation and remains a stable part of the portfolio. Finally, farmland values have held up, despite volatility in commodity markets.
What Are We Thinking About?
We’ve had a few clients ask if now is the time to be opportunistic. This is something we are very focused on, as part of what will help recovery happen more quickly is taking advantage of some of the dislocations occurring in markets. We do expect at some point to rebalance to equities, but at the firm level, we believe it’s too early to do that today. Markets have yet to find their footing, and we may see further declines once companies start to report earnings. In the meantime, opportunities are appearing in credit markets that we may begin to discuss with clients. MRA has been working with our investment firm partners to identify solutions where we can be opportunistic without substantial additional risk. In some cases, these may be unique to MRA and our clients. We will continue to look for ways to add value in a time when markets become much less efficient and present more opportunities.
Finally, we want to encourage all of our clients to continue to communicate regularly with your engagement team. Despite working from home, MRA is fully operational. Every member of our team has access to all of our tools and resources, and all team members are equipped to do their jobs as effectively from home as if they were in the office. Our culture of risk management and preparation extends beyond investing into our business operations. If you’re concerned about markets or your portfolio, please reach out. Let us know how you’re feeling. We will continue to provide regular updates as conditions evolve, but we are here for you anytime.