Calibrating portfolio positioning through the Coronavirus crisis
Pramit Ghose
Pramit Ghose

As lockdown measures start to ease across Europe and Q1 company results and outlooks are not as bad as feared, we wonder perhaps if the equity markets bottomed out around March 23rd. It will take a few months to know whether we did see the bottom, or if the rally of the past few weeks has been a false rally within a bear market and we return again to those very low market levels. What we do know is that the fall between late February to late March was the most rapid ever while the recovery since March 23rd has also been sharp and rapid.

For investors looking out 12 to 18 months and longer, history in the form of the Spanish Flu of 1918-1919 offers a positive outlook. There were three waves of the Spanish flu throughout 1918 and 1919; March 1918 for a few months, October to December 1918, and a final wave in the spring of 1919. After that the virus more or less disappeared, probably due to improved treatments, or a mutation into a less lethal form. During this pandemic, in which some 500m people were infected (a third of the world’s population then) and death estimates range from 20m to 50m [source: Stanford], there were similar lockdowns and economic disruptions and sharp drops in demand as the current COVID-19 one.

You might be surprised at the performance of the US equity market (and equity styles within the US market) over this period. Markets had peaked in late 1916, but then dropped about 20% into late 1917 due to concerns around World War 1. After that, as the war came to an end, markets started to recover, with a relatively modest c.5% dip in the spring of 1918 as the first wave of the Spanish Flu hit. Thereafter, despite the two further pandemic waves, markets continued to recover, and by February 1919 had recovered all the losses since the late 1916 peak (source: Robeco).

If we were to follow a similar pattern, assuming as with the Spanish Flu that after 12 to 15 months the Coronavirus is under control and life heading back to ‘normality’ albeit with some significant lifestyle changes, then we could be looking at equity markets re-attaining their February 2020 levels (some 25% higher than current levels) around early/mid 2022. It’s not an unrealistic outcome if we get the virus under control and a vaccine available by mid-2021. If equity markets get back to within 10% of the February 2020 levels by early 2022, then, with dividends (yes, there are still plenty being paid!), one is looking at about a mid-teens return, still attractive versus zero or negative on Euro deposits or high quality Euro sovereign bonds.

The short-term is probably more difficult to gauge. We’ve had a rebound, the markets seem more relaxed about the path of lockdown easing and economic recovery than perhaps reality. Any setbacks in lockdown easing, mortality rates, or a re-infection scenario, could lead to another sharp setback. History suggests market setbacks are likely in the path to recovery, and the two most recent significant bear markets, the Tech bear market in 2000 – 2003 and the Financial Crisis bear market in 2007 to 2009, had a zig-zag path to recovery. See chart below, courtesy of Bank of America:

Source:Bank of America

Warning: Past Performance is not a reliable indicator of future performance.

One could argue the current market (blue) is sort of tracking the 2008 path (orange), which would suggest another downleg over the summer (as do the 1987 and 2002 paths).

Nobody knows the likely short-term path of financial markets and managing client expectations through this period is difficult. Investors look out 18 to 24 months and see the recovery potential as outlined earlier, and naturally want us to ensure their funds with us participate and benefit from the recovery potential. But they also see how everyday life has been affected by the lockdowns and, if they haven’t lost their jobs, had to restructure or close down their businesses, have certainly got friends who have. And we are all pushing out our expectations of travel and going to bars, restaurants or concerts. So, they are naturally concerned the markets have another downleg or two in the path to recovery, and so want us to protect their assets. That leaves us with the difficult path of managing downside risk while simultaneously positioning portfolios to benefit from upside potential.

Hence the title of this article…’calibrating portfolio positioning’. The medium-term view looking out to late 2021 looks reasonably attractive, as:
– Asset prices have declined significantly
– The financial market risks of the virus have been recognised and understood, even if uncertainty remains
– investors are (naturally) cautious and risk averse, usually a good time to invest.

The short term, however, remains very uncertain, but it seems like the world is looking out to a recovery phase from the coronavirus. Governments and the monetary authorities have acted quickly to mitigate extreme financial stresses, hence in our view the likelihood of markets dropping 20% sharply has reduced. Of course we will have volatility throughout the coming months as we get setbacks in the virus recovery phase; we would actually like some setbacks in markets (but not the virus recovery path) to be able to continue to calibrate portfolios to less defensive positioning. Averaging-in new cashflows and pro-cyclical stock positions is a patience game – we would lose out relatively if there’s a sharp move up in markets over the next few weeks towards the February highs, but otherwise it has the best risk/reward ratio in terms of calibrating portfolio positioning, improving upside potential while still maintaining reasonable portfolio protection. As renowned US investor Howard Marks wrote recently: ‘conditions have changed such that caution is no longer an imperative’.

Pramit Ghose is Global Strategist with Cantor Fitzgerald Ireland.

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Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up.