March 25, 2020
We would like to provide an update on our investment strategy following our asset allocation committee which was held yesterday, 24th March.
Firstly, we have adjusted our macroeconomic base case scenario in light of the coronavirus pandemic. Due to the unprecedented nature of today’s circumstances whereby economies have been forcibly shut down by governments, there are no historical points of comparison. This means that the eventual outcome is subject to a high degree of uncertainty, however, we have pieced together what we believe to be the most probable economic evolution.
We see two phases:
- A containment-induced drop in supply & demand,
- A stabilisation followed by a rebound after policies that weigh on GDP are lifted (quarantines, travel restrictions…)
Phase 1 will result in a profound, yet brief economic shock, affecting the tail-end of the first quarter and most probably all of Q2. In this phase, the macro landscape will be ugly. Consumption and investment will collapse and the impact on corporates will be huge: it’s not unreasonable to expect that most of their top-line will be wiped out for at least three months. Despite this, a broad liquidity crisis or credit crunch is not expected, thanks to public and monetary intervention, but there will damage, especially for small and medium enterprises (SMEs). However, this is not the dawn of an economic ice age or a great recession. Based on what we are already starting to see in China, in Q3, we expect the cogs of the economy to gradually start turning again. We should start to see a progressive stabilisation, with consumption and investment starting to turn.
This two-phase narrative assumes that governments and central banks will keep intervening to “do the right thing” i.e. put down the rulebook if they must in order to ensure ample credit availability to allow survival, thereby averting the formation of a negative feedback loop. Targeted policies to avert insolvencies and job losses are essential, otherwise the risk is that Phase 1 is prolonged. However, this is not our base case given the amount of monetary and fiscal firepower being deployed.
In light of this base case, we have made some adjustments to our portfolios.
Our equity allocations have been subject to a ‘portfolio drift’ affect (their decline in market value naturally meant that as at yesterday, they accounted for a smaller portion of our portfolio than they did before the sell-off). We decided to rectify this and brought our equity positioning back to neutral by cherry-picking high quality names.
Quality stocks should be understood as those which have been screened using a set of clearly defined fundamental criteria to ensure enduring balance sheet strength. For us this means screening companies to identify those with high cash levels, low debt levels, and high levels of free cash flow while avoiding sectors/activities which are at acute risk of disruption in the current context.
The key rationale for this decision is the fact that before the economic data starts to improve, markets will have already rebounded. While we acknowledge that the situation could get worse before it gets better, we believe that equities, especially these high quality names, will eventually bounce back. We take advantage of attractive valuations while they persist.
The second adjustment was made inside of our Government bond exposure. While the overall allocation to this asset class was held steady, we increased our euro-hedged US Treasury exposure towards 20% of the total government bond exposure. We did so by selling a proportionate amount of European Government Bonds. The primary reason for this is to diversify interest curve risk. If the situation deteriorates, Treasuries have more room to move downwards, in terms of yield, than European equivalents.
Author: Group Investment Office