1. Why are we having such dramatic swings in the equity markets in this COVID-19 situation compared with historical swings that were more “normal” in size in previous downturns?
There are likely several reasons the market has been gyrating as wildly as it did in March. First, the spread of the coronavirus presents a large, relatively unknown outcome, and market participants are trying to discount future earnings streams of companies impacted by the virus, which is simply hard to do. There are no good modern historical comparisons to rely on, which makes discounting future earning streams even more difficult. And with the magnitude of this crisis, while we have had several fiscal policy responses thus far, most recently with the $2 trillion CARES Act, it will take some time for these responses to alleviate the economic and financial pain we are seeing.
The second thing to note is that the market structure is wildly different in this downturn than in prior ones. There have been many questions in recent years about how the rise of passive investing and ETFs would affect markets (potentially exacerbating market downturns), and we are likely seeing the selling by index funds and ETFs increasing market volatility.
Lastly, the speed with which this crisis has come upon us is unprecedented, so it is natural that market moves have also been larger. It is worth noting that with recent moves, the markets are back to January 2019 levels, and it took just a few short weeks to undo over 14 months of gains.1
2. What is your framework for rebalancing? When is the right time to add to equities?
The Brown Brothers Harriman (BBH) Investment Research Group’s (IRG) primary role is to ensure that our clients’ portfolios are well-positioned for the long term. As part of that process, IRG thinks critically about portfolio construction and manager selection to ensure that our clients’ capital is invested in securities that provide the best risk-adjusted returns.
In this most recent bear market, we have been getting a number of questions from clients as to whether or not this is the time to lean into equities. Unfortunately, without a crystal ball, it is impossible to make a top-down call on when to re-enter the equity markets. Instead, we rely on our managers to make fundamental bottom-up decisions on their portfolios and to take advantage of situations where share prices have diverged from companies’ intrinsic values. As this volatility unfolded, all of our managers have taken the opportunity to deploy cash and upgrade their portfolios, essentially taking the first step of rebalancing portfolios for clients. Further rebalancing will be warranted as equity and fixed income allocations move away from allocation targets. Given the great uncertainty surrounding the COVID-19 crisis, we are recommending that this rebalancing be done only in an incremental and gradual way.
3. Why was there such a dislocation in fixed income markets? And what has the Federal Reserve done to help address the situation?
Fixed income markets in March 2020 provide an interesting and historical case study. While the equity markets peaked on February 19, credit markets didn’t begin to sell off until March 4. In addition, from February 19 to March 9, the U.S. Treasury market responded as expected, with yields declining sharply in response to a global flight to safety. On March 9, as the COVID-19 crisis intensified, a massive rush for liquidity began to overwhelm this traditional flight to safety. For a time, even the Treasury market was not immune to these pressures. From March 9 through March 18, for example, the Barclays 10+ Year Treasury Index declined almost 16%, and 10-year Treasury yields actually rose from 0.54% to 1.19%. During this period, cash was the only fixed income sector that had positive performance. For the entire month of March, the Barclays U.S. Aggregate Bond Index, with a 43% weight to Treasuries, posted a return of -0.6%.
The credit markets have begun to recover but, despite massive intervention by the Fed, are not back to levels before the COVID-19 crisis. For example, a U.S. Corporate 1-5 Year BBB-Rated Index trades at a spread over 30 basis points wider than the longer-duration U.S. Corporate 5-10 Year Index.2 In more normal market environments, shorter-duration credit spreads are narrower, which indicates that pricing pressures are continuing to negatively affect the short portion of the yield curve.
So what actions has the Federal Reserve taken? After aggressively cutting interest rates in early and mid-March, the Fed began addressing liquidity concerns in fixed income markets on March 17. Its policies have addressed dislocations (supply and demand imbalances) in money market and commercial paper markets, overnight funding markets, primary and secondary corporate issuance and asset-backed security markets, to name a few. Throughout the past few weeks, the Federal Reserve has acted with unprecedented size and speed and has indicated that it is committed to continuing to use its balance sheet to restore liquidity to fixed income markets. The nearby table provides an overview of the Fed’s recent initiatives.
4. Why is this current environment well-suited to active management?
The COVID-19 pandemic has created panic in financial markets and will certainly have a negative economic impact across the world for some period of time. However, over the next few years, the global economy will likely recover from this negative impact, and companies that have staying power will be the beneficiaries. There will be many winners and losers, as there are in all crises. We have already seen that the energy and financial sectors have been the most punished in the S&P 500. While we do not make top-down decisions to avoid certain sectors, we do prefer to own companies with superior business models and limited capital spending requirements, less cyclicality and lower financial leverage. Therefore, it is not surprising that our portfolios were underweight to these more cyclical sectors. As always, we take comfort in investing with managers who have significant wealth invested alongside our clients and who are spending their time analyzing and stress testing their portfolios to invest in the most resilient, mission-critical businesses with proven cash flows and conservative balance sheets. These businesses will be best positioned to succeed when the COVID-19 crisis is resolved.
Finally, we thought it was worth repeating a quote from Rudyard Kipling that one of our managers shared with us on a recent investor call. It is truer today than ever!
“If you can keep your head when all about you are losing theirs …
If you can wait and not be tired by waiting …
If you can think – and not make thoughts your aim …
If you can trust yourself when all men doubt you …
Yours is the Earth and everything that’s in it.”
-Rudyard Kipling, “If”
Past performance does not guarantee future results.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03466-2020-04-02
1 As measured by the S&P 500. Data as of April 1, 2020.
2 One “basis point,” or “bp,” is 1/100th of a percent (0.01% or 0.0001). ICE/BofA U.S. Corporate Indices. Data as of March 31, 2020.