It’s been a crazy week in financial markets. Equities have fallen, but so have traditional ‘safe havens’ like gold – and we’ve even seen signs of stress in the mighty US Treasury market. But it’s important to remain calm.
Our portfolios continue to perform as we’d expect, with diversification across global regions, asset classes and currencies mitigating short-term damage to capital – especially for our more cautious clients.
Most of our defensive tactical positions have performed well. We have stuck to our process and done some disciplined profit-taking – there’s no point in doing well on the way down, only to give it all back if markets rise:
• US healthcare companies have been very defensive, outperforming the wider index by almost 10% over the past few weeks. In the long run we still believe these stocks will outperform, but have cut back our position slightly, to bank recent gains.
• Our custom basket of alternatives has done everything we could have asked. The more defensive strategies have risen strongly, beating even government bonds over the past few days. We have been making sure that we keep the basket evenly balanced, trimming the strong performers, and reallocating as necessary.
Shutting borders and keeping people inside their homes has a negative impact on economic growth. People will buy less, sell less, and make less. In addition, it will feel extremely uncomfortable in the Western world to be told that we cannot do certain things.
However, this is likely to be a temporary shock – not as short-lived as investors believed a month ago, but certainly not a permanent state of affairs. We are optimistic that the spread of COVID-19 will be contained over the course of the year. Authorities around the world are moving in the right direction, if not all at the same speed. Expert advice is being listened to and populations are working together. Stopping the loss of human life is the priority, as it should be.
Thus far, the actions taken to preserve our physical health have not been positive for financial assets like equities and commodities. Many equity markets are down nearly 30% this year. We believe this is a panicky overreaction and will give long-term investors lots of opportunities over the next few months.
We are fortunate. Our blend of strategic and tactical positioning has put us in a position to start looking out for some of these opportunities. Risk management
is at the heart of our process, and will remain so.
Risk and stress testing
Loss aversion is the common tendency for people to weight losses more than they weight equivalent gains. You feel more pain from a 10% fall in the market than you feel joy from a 10% gain.
These emotional reactions are important. Our clients feel these emotions (and so do we!), so being able to manage the risk of big potential losses is as important as being able to manage day-to-day volatility. One of the techniques we use to help manage this risk at 7IM is stress testing.
We consistently run our portfolios through over 20 of the biggest historical market shocks (e.g. the 2008 financial crisis), as well as the worst hypothetical scenarios we can imagine. We couldn’t have predicted COVID-19, but we’ve seen the size and direction of such market shocks before, and we factor these tail risks into our portfolio process.
By integrating stress testing into our investment and risk management process, we can:
• Ensure we have exposure to a more diversified set of risk factors/return drivers
• Manage tail risks as well as volatility (standard deviation)
• Feel more comfortable and react better when we do experience losses
• Understand market events and shocks quicker
• Make better decisions and deliver better risk adjusted outcomes (returns) for our clients
So, while stress testing won’t guarantee a happy outcome it can help us prepare for the how we might feel. And then we can hopefully manage those emotions – for us, and for our clients.
Looking further out, COVID-19 is going to make its mark on our society – and on investors. The virus and quarantine could change us all.
Politicians’ habits will have to change, as governments and politicians define their legacies by their actions, not just their words. Working habits could change, as face-to-face meetings are curbed and office-work becomes less common. Health habits will change, as medical services are pushed to the limits – medication and diagnosis are not going to be available on demand. Tourism, social interaction and entertainment will change – what will replace live sports, Broadway shows, restaurants, and foreign holidays? And are technology companies robust enough to provide their services in the face of unprecedented demand?
Some of these changes will have long-lasting impacts, while some will be more temporary. The market is having a hard time deciphering which will be which. What is important right now is not just jumping straight back in. Instead, we’re spending much of our time trying to look through the noise, to find the right signals.