Since the end of February, we have seen news around the Coronavirus, which was first discovered in China in early January, continue to emerge at a fast and furious pace. As cases of the virus have been diagnosed around the world, U.S. and global markets have responded sharply to what they view as a potential slow-down related to spread of the disease.
Several weeks ago, market observers generally laid out a simplistic 3 scenario model from best to worst case in determining how the impact from the Coronavirus would transpire. While previously those observers were leaning in a more optimistic direction, they are now mostly between the middle and worst-case outcome. Relatively few now assume the best case today.
With Monday’s sell-off, and Tuesday and Wednesday’s whipsaw, equity markets are now down more than 10% YTD and approaching a 20% decline from the peak. The corresponding flight to treasuries pushed yields to all-time lows across several parts of the core fixed income market, helping to mitigate some impact of the equity declines. We mentioned just recently in our 1st quarter video recap that investors should prepare themselves at any time for a sizable contraction in markets, and we consistently stress the importance of diversification in protection from excessive downside risk. That message continues to ring true today.
Knowing the flurry of volatility investors have now seen, especially after the longest bull market in recorded history, we’re sharing some thoughts we have around common questions our investment team is receiving.
What is the rationale for not aggressively increasing equity allocations with this roughly 20% move?
We are still not near valuations experienced as recently as late 2018, and while we do not see any “screaming” bargains yet, some advisors are looking for bargains and opportunities to rebalance, which we would be buying incrementally.
What is the rationale for not aggressively selling equities here with all the unknowns?
Versus say 2008 (Global Financial Crisis) and 2011 (U.S.A. downgrade) which were big macro events characterized by potential banking system failure, the current episode feels more limited in duration. There will certainly be companies that cannot survive 1-2 months of severe business declines and there will be sectors more at risk, however the “math” of epidemics and pandemics suggest this should have 1) significant impacts but 2) for a finite amount of time. Further, there could be government policy responses which significantly change the trajectory of financial asset prices, risking us getting whipsawed.
What is the rationale for not reducing fixed income?
U.S. Treasuries have indeed seen the greatest demand and thus decline in yields and are yielding less than 1% across the entire maturity range. Most other high-grade fixed income sectors have seen a decline in yields but not nearly to the same degree as Treasuries. For instance, municipal bond yield declines have only been ~ 1/3 of Treasuries year-to-date and thus are offering compelling relative value. Riskier satellite fixed income such as corporate credit has seen its yields increase. Remember, none of our active fixed income managers allocate solely to Treasuries, so they are evaluating these relative risk / reward trade-offs.
What is the investment team thinking about now?
We are reminding our clients that periodic market turmoil is contemplated in the returns we use in coming up with your financial plan. And that times like these are why you have the plan. We are talking to our managers to confirm they continue to do what we intend. We are looking at adding other asset classes which may provide the diversification with equities that we seek with fixed income but with more compelling yields. Advisors may also talk to you about financial planning techniques that become more interesting after market declines such as this.
Controlling what we can control
We further remind ourselves (and you) that diversification once again has helped alleviate the full stress of a market drawdown. Diversified investors likely benefited from other areas of their portfolio performing well, namely fixed income exposure. This also helps with the psychological (or behavioral finance) side of investing – hopefully it reduces the sticker shock from a market drawdown and thus the chance an investor makes a wrong decision at a wrong time. We are likely to rebalance into this market weakness, as buying equities here to get back to target weights systematically implements the old market adage to “buy low and sell high.” We will also likely be tax loss harvesting to generate tax losses which may be used elsewhere. Not only are these things we can control, they have shown to add-up into a material benefit over the long run.
None of us like to see our portfolios decline, especially rapidly and significantly. However, we also know that this happens periodically. Events may develop that would lead us to change our thinking on the above and we will keep you posted. Most importantly, for those of you located in areas with significant current exposure to the virus, please look out for yourself and loved ones. We are doing the same here.