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Up close & personal
OVER the past weeks as the global spread of Covid-19 intensified, the prognosis for the global economy has dimmed sharply. Volatility has dogged markets despite the concerted efforts by central banks to cushion the fallout. As at early April, the major US indices such as Dow Jones Industrial Average and S&P500 have lost about a quarter of their value since January.
One way to take the stress out of investments is to entrust your portfolio to a professional manager, by way of a discretionary portfolio account. Those who do so are likely to sleep better at night.
We speak to Norman Villamin, Union Bancaire Privee's chief investment officer (wealth management), on his views and the steps he has taken - and continues to take - to preserve clients' assets in these trying times.
Markets have been put through a wringer in the past two to three weeks. What factors have been priced into markets and what factors haven't been priced in?
Mr Villamin: Think about where we were in January. We had the virus shock in China. Most people took the approach of Sars (severe acute respiratory syndrome) in 200203, that we would have a demand shock - things go sharply down, and then things get better and a sharp recovery happens.
What we're seeing now is that a demand shock has morphed into supply and to the rest of the world. In just the past month, a regional shock has become a global shock. So it's clear that the assumption that we would have a Sars-like pattern in markets was not a good one. As we can see, the response out of Europe and the US to Covid19 has been less aggressive and robust than China. The four to five weeks that it took for China to get stabilisation may take longer in Europe and the US.
There is a second concern. In Asia, governments in the richer economies like Singapore and China have reached out to help companies and individuals. There is a lot of debt expansion, capital raising and restructuring to allow them to stay current.
That has prevented a big credit (contraction) cycle from moving through to the economy. But what we see in Europe and to a large extent the US is that credit markets are starting to price in a credit contraction, which adds to the economic and demand shock. We don't believe markets have fully priced that in. At the moment, credit spreads are at around 900-1,000 basis points, compared to a typical recession at around 1,000 basis points. However, a full blown credit contagion, like in 2008 isn't fully priced in.
What scenarios do you posit, and what is your base case?
Mr Villamin: We see three scenarios. One is a liquidity and demand shock scenario; a contained credit scenario like in 201516 - we're close to pricing that now. And the last one is most worrisome, which is a broad contagion of credit where people question the solvency of banks. We don't think that's the base case right now. There are lots of fiscal measures starting to be deployed. The longer it takes to bring fiscal measures in to ease financial conditions and the longer the demand shock continues, the greater the risk that this scenario materialises.
Our base case right now is a contained credit-cycle scenario. Europe and the US are moving through it right now. You'll see more volatility from here - 10 to 15 per cent more downside in global equities, and a bit more volatility in credit spreads. Essentially, what investors are facing is a tug of war between the ongoing demand destruction from the spread of the virus and the increasing fiscal and monetary stimulus. Given that the US in particular is still in its acceleration phase, we suspect we may see a stalemate in the near-term until an easing in pressure from the virus can be seen.
What are you doing in portfolios; how have you managed to preserve clients' capital?
Mr Villamin: We are pursuing a dynamic approach. At the start of the year, we were cautiously bullish but we worried about elevated valuations across just about every asset class. Because of this, we tried to create an asymmetric risk/reward to get as much participation on the upside, but less than one-to-one on the downside. To do that, we created a portfolio within the portfolio of essentially risk-off assets.
First, in December we bought longdated government bonds. The second piece we started doing in December is we bought call options on the S&P 500 to participate on the upside. If markets had fallen we only stood to lose the premium. We also invested heavily in equity long/short hedge funds. Back then, volatility was low and we could structure products that gave us protection on the downside and participation on the upside. As we moved through January, markets rallied and we pivoted. We shifted from call options on the market which have done well, to buying puts. We were going to protect the positions we had in case markets fell. We shifted most of our long-only exposure in equities into structured solutions that contained the downside but still allowed upside participation. As we moved through February, volatility picked up, and it was difficult to find hedges. We started making the shift into risk-off currencies as well, the Swiss franc and Japanese yen. In March, we've been buying out-of-themoney options on gold primarily to protect against the credit contagion.
On our balanced portfolios, we're roughly -5 per cent in the first quarter. When we think about our ultra high net worth clients, in difficult markets like this, we want to focus on preserving capital. Only after we have put that preservation piece in place in portfolios do we focus on growth. Many investors want to start with and reach for growth but at UBP, we want to make sure that in difficult market conditions where the risk/reward is against the clients, we focus first on preservation.
How do you think issues in markets will get resolved looking out on a three to six month horizon?
Mr Villamin: In terms of getting back on our feet, there are two ways to do it. One is what we saw in 1997-98, where we had a big deleveraging cycle in Asia, and banks were restructured. It tends to be very painful, but it's probably the most sustainable path. The more politically palatable way is to continue relevering, and this is China's dilemma, where they keep supporting non-functioning corporates and state owned enterprises.
In a scenario of debt funded stimulus in the US and Europe, their long-term sustainability is probably questionable. If you saw efforts to delever and get some structural reforms going, it may take longer and be more painful and less rewarding for market participants.
But it will be more sustainable on a five to 10 year view. Look at what China is doing. Infections have stabilised and it's clear they're not looking to restart activity very rapidly to get to 6 per cent growth. I suspect what China will do is to use this downturn as an opportunity to pursue reforms that they wanted to do anyway, such as the expansion of the healthcare system, the social safety net system and restructure banking.