MARKET UPDATE AND CHANGE TO THE REBALANCING THRESHOLD FOR PRIVATE CLIENT MANAGED PORTFOLIOS
2020 was set to become a pretty good year for earnings and economic growth, due in part to lower interest rates. However, markets have been negatively impacted in recent weeks by both the spread of COVID-19 (coronavirus) and an oil price shock. The coronavirus began in December 2019 in China, and North American markets initially responded much like they had during the SARS outbreak of 2003, which was quickly contained. Unfortunately, coronavirus has spread across the globe and shattered consumer confidence. The virus is having a large impact on consumption as people are staying home, not travelling or self isolating. There has been a significant disruption in China with the supply chain operating at about 20% capacity. The good news is that China is seeing fewer cases of the virus each day and things are already starting to improve. There is a great deal of uncertainty so it is hard to know what the ultimate impact will be on earnings.
Oil price war
It was expected that the Organization of the Petroleum Exporting Countries (OPEC) nations would slow the production of oil, but Saudi Arabia, in a conflict with Russia, started increasing production to initiate a price war. This was unexpected, driving the price of crude as low as US$30 per barrel and officially into bear market territory on Monday, March 9, 2020. While there will be negative repercussions for oil-producing economies, low oil prices can create benefits for consumers via lower fuel and energy prices. It is hard to predict how long the current price war will go on, but we expect that Russian and U.S. shale producers will struggle because they are profitable at US$40 and US$50 per barrel respectively.
Coronavirus impact and policy response
From February 19 to March 16, markets were spooked by the spread of coronavirus and dropped about 10%, while foreign currencies all rallied against the Canadian dollar. Why are foreign currencies doing better than the U.S. and Canadian dollars? Before the virus outbreak, Canada and the U.S. were high-yielding currencies with central bank rates at 1.50% to 1.75% higher than the rest of the world, which were at 0% or 0.25%. The U.S. has cut to 0% and markets are expecting Canada to follow suit, which would eliminate their interest rate advantage.
While central banks and governments are being criticized for not doing enough and not moving fast enough, they have reacted very quickly compared to other crises. With tools like quantitative easing already in place, central banks can buy government bonds, corporate bonds, income trust and stocks without needing to wait for a new financial tool to be engineered. Central banks and governments are providing economic stimulus packages that are targeting the real economy so more people will benefit. There are plans for more fiscal spending and tax cuts so it’s not just those with financial assets who will benefit.
On March 3, the U.S. Federal Reserve made an emergency cut of 50 basis points (bps), taking interest rates to a range of 1% to 1.25%. Then, on March 15, the Fed announced an emergency rate cut to a range of 0 to 0.25% and reinstated quantitative easing with plans to purchase $700 billion in Treasury and mortgage-backed securities. The Bank of Canada cut 50 bps to 1.25% and followed up with another emergency 50 bps cut to 0.75% just a week later. The European Central Bank (ECB) did not cut interest rates because they are already negative, but they are providing funding to small businesses to help fund their operations and expanding their asset purchase program. The ECB is also allowing banks to relax their reserve ratio to allow for more lending, while individual countries are being allowed to run larger budget deficits and do more spending. China is also being very aggressive to ensure the credit market is fluid, pumping money into the system, cutting reserve and interest rates. If this isn’t enough, there will likely be more coming as it is in everyone’s interest to avoid a recession.
Over the past few weeks, the best performing sectors were consumer staples, health care and utilities. The worst performing sectors were energy and financials because of declining interest rates. It’s harder for banks to have good margins in a declining interest rate environment and more people are worried about a recession.
How we are positioned
Being significantly overweight risk assets during a strong year in the stock market benefited our programs in 2019, and an underweight allocation to fixed income also contributed as bond yields backed up towards the end of the year. We entered 2020 more constructive on risk assets, because pre-virus, it looked like GDP growth would be revised upward given the effects of looser monetary policy.
Looking forward, we believe that equity will provide better returns than fixed income for investors with long time horizons and have an overweight in balanced and growth portfolios. Broadly speaking, we’re overweight defensive factors (momentum, low volatility) and sectors (staples, health care, utilities, real estate); there will be an opportunity for cyclicals to emerge, but we think it is too early to add exposure. We’re adding to equity in this drawdown in longer-term portfolios but are being less aggressive in more conservative portfolios for those who need liquidity.
Within fixed income, our view is that government bonds are offering a lot of return-free risk. Negative real rates of return across the entire yield complex in terms of sovereign bonds doesn’t square with the solid market environment we saw pre-virus. Tactically, we are lighter on credit exposure and, more broadly, are underweight high yield and emerging markets. We’re underweight bonds overall, including governments, seeing no long-term value there at all. We are seeking alternative defensive strategies including the yen, U.S. dollar and gold.
The portfolio rebalancing threshold for the Private Client Managed Portfolios program is typically set at 10%. That level is designed for normal market conditions when daily volatility is generally +/- 2% at most. In the last few days, we have seen daily volatility spike to an average of about 4% and have had some daily moves up and down by as much as 10%. In response, we are actively managing the rebalancing threshold to offset the extreme conditions and navigate lower liquidity in certain asset classes.
We remain committed to the philosophy that automatic rebalancing adds value by systematically buying low and selling high for investors. After several days of declines, portfolios were rebalanced which led the programs to sell Canadian and global fixed income, and buy Canadian and U.S. equities. We will continue to be active with the rebalancing thresholds as long as extreme market conditions persist.
Source: CI Multi-Asset Management, as at March 16, 2020.