Investing Against COVID-19
The disappointment started in earnest when Italy was shuttered, and then was aggravated by the U.S. ban on inbound travel from Europe. Now, roughly five months later, the COVID-19 pandemic and its push and pull on the financial markets rank No. 1—or nearly so—on the agenda of every adviser, plan sponsor and participant. Accordingly, we thought advisers might value a review of the thought processes and priorities of a few widely held target-date fund (TDF)s’ managers.
Confronting the Virus
With the wind at their backs from the start of the year, some managers arrived at the COVID-19 outbreak with bullish views on the equity markets. “Coming into the crisis, we were 3% or 4% above the midpoint of our TDF glide path allocation,” recalls Dan Oldroyd, portfolio manager and head of target-date strategies at J.P. Morgan Asset Management in New York City. “We got ourselves back to neutral at the end of February, and through March down to an underweight of 3% to 4%. Our biggest concern at that point was how bad things might get, so it wasn’t until mid-April that we started to put money back to work and return to an overweight.”
But managers are not unanimous on whether it is safe to go back in the water. “We were slightly overweight on equities in our TDFs at the start of the year, but when equities took their precipitous fall in March, we added to our exposure to stocks—4% over our neutral weighting for stocks at one point,” says Mark Vaselkiv, fixed income chief investment officer (CIO) at T. Rowe Price Group in Baltimore and a specialist in high-yield bonds. “We find ourselves neutral again today, at about 65% equity. We largely see the markets as ahead of themselves, as they are forecasting a lot of good things—economic recovery and a vaccine. But there’s still way too much uncertainty.”
At Fidelity Investments, portfolio managers faced the COVID-19 storm already wearing foul-weather gear, having previously scaled back on risk. “The first-order protection for a TDF is diversification, and during the last few years we had increased our diversification strategically and reduced our equities, particularly for the older investors,” explains Boston-based Andrew Dierdorf, one of three Fidelity TDF portfolio managers. “We didn’t see a pandemic coming; I don’t think anyone was forecasting that. But we did see signs that uncertainty was increasing—things such as terrorists were in the dialog more often and ‘peak globalization.’ We saw less central bank and government policy coordination around the world, which can lead to greater volatility, so in 2018 we reduced our equity allocation for those in or near retirement by up to 5% and added to long Treasury bonds and TIPS [Treasury inflation-protected securities].”
New Threats Need New Data
“In market shocks, we’re used to basing decisions on cash flow forecasts for companies, fiscal or monetary policy changes or election outcomes,” says Oldroyd. “This one calls for new information sources, and what has been so challenging is that science is slow and methodical, and does not move at the rapid speed of the markets.”
For more rapid insights, J.P. Morgan called on more rapid information sources. “We have to weigh our confidence in our forecasts of tail risk,” Oldroyd adds, “and one shift we have made is to look at very short-term data, such as credit card charge volumes. We knew that the new data might be volatile, but we thought it might give better clues, and it was that information that helped us with the decision to raise our equity allocations.”
New data sources allow a more timely reveal of the big picture as well, from the markets’ aggregate view of a recovery in corporate profits. Drawing from the dividend futures market, two creative academics at the University of Chicago have deconstructed investors’ year-by-year expectations for dividends for the U.S. and European stock markets and, by implication, corporate profits and the global economy. In their June paper “Coronavirus: Impact on Stock Prices and Growth Expectations,” Niels Gormsen and Ralph Koijen wrote, “As the current situation is unprecedented and evolving rapidly, models that use macroeconomic fundamentals to form expectations may miss some of the key forces and may be too slow to update.”
Dividend futures trade separately by vintage year and provide insight into when investors expect growth to occur. “One-year dividend growth expectations did not respond much to the [initial] Wuhan lockdown,” Gormsen and Koijen wrote. However, expectations for growth in Standard & Poor’s (S&P) 500 index dividends one year out had faded as much as 30% by early April, when the index level had fallen by roughly as much. By June 8, expected S&P 500 dividend growth over the next year had recovered to a drop of 9%; at that time, the index stood about 10% below its February 19 high of 3386.
History Lessons
Do past market calamities provide guidance for investing against COVID-19? “The Fed says it may undertake a policy of yield-curve control,” James Grant, a scholar of financial history and editor of “Grant’s Interest Rate Observer,” in New York City, told PLANADVISER in an exchange of emails. “The last is not unprecedented—the Fed pegged yields between 1942 and 1951, but that was a wartime expedient. It will be said that COVID-19 is the viral equivalent of war, but the Fed, along with the other major world central banks, has been intervening more and more aggressively with each successive crisis.”
The global financial crisis brought a large response from the Fed, but the current assistance is much broader and came more quickly, Grant adds. “So we are in monetarily uncharted waters.”
Dierdorf echoed the unusual circumstances. “You can look at events where there have been recessions, and depressions, and pandemics, but they were not countered by the level and speed of monetary and fiscal response we’ve seen with COVID-19.”
“By the end of March, it was clear we were in a recessionary bear market, and for those sorts of markets, history suggests a more protracted recovery period,” says Charles Shriver, portfolio manager of T. Rowe Price Group’s Global Allocation Fund, and co-chair of the firm’s asset allocation committee, in Baltimore. “Those recessions are brought on by policy dislocations—the Fed overtightening on interest rates, or the oil embargo in the 1970s. With COVID-19, in effect there is a policy element from a health care perspective. We don’t know when we’ll get a vaccine, though there is general confidence it will be in 2021. But it will take time. That suggests a deep economic and earnings trough, and the question is whether some segments of the economy will see a permanent impairment.”
The market-moving power of the current government assistance is illustrated in the accompanying chart, which plots the five significant drops and recoveries in the S&P 500 since 1972, plus the COVID-19 crisis of the current year. On average, the trip to the bottom and the climb back to the prior high took about 42 months. This time, the S&P 500 made its drop faster than in any recent decline, but as of June 30 the index was back to within 8% of its pre-COVID high, and in just six months.
Absent a historical precedent to guide their investing, investment managers are concocting as many possible outcomes as they can think of. “We’re not thinking Plan A versus Plan B, but rather Plan A, B, C, D, E …,” says Vaselkiv. “The outcomes will vary by region of the world, by states in the U.S., and south versus north of the Mason-Dixon line. And there will be dispersion across industries. To put it simply, we’ve moved more of our TDF weightings back to the U.S., for three reasons—the greater strength of U.S. corporations, our confidence in Fed Chairman [Jerome] Powell and his commitment to provide unlimited resources, and the quality of the U.S. capital markets in providing financing to companies that need bridges to recovery.” —John Keefe
Duration of U.S. Stock Market Declines and Recoveries, 1972 – Q2 2020
Index of Recovery
120%
1976 –1978
1972 –1976
2000 – 2006
1981 –1982
2020
2007 – 2012
100%
80%
60%
40%
0
6
12
18
24
30
36
42
48
54
60
66
72
Months from market peak to trough, and return to peak
120%
1976 –1978
1972 –1976
2000 – 2006
1981 –1982
2020
2007 – 2012
100%
80%
60%
40%
0
6
12
18
24
30
36
42
48
54
60
66
72
Months from market peak to trough, and return to peak
120%
1976 –1978
1972 –1976
2000 – 2006
1981 –1982
2020
2007 – 2012
100%
80%
60%
40%
0
6
12
18
24
30
36
42
48
54
60
66
72
Months from market peak to trough, and return to peak
120%
1976 –1978
2000 – 2006
1972 –1976
1981 –1982
2020
2007 – 2012
100%
80%
60%
40%
0
6
12
18
24
30
36
42
48
54
60
66
72
Months from market peak to trough, and return to peak
For calendar years in which the S&P 500 declined 10% or more—i.e., five instances between 1970 and June 30, 2020—the time from peak to trough and back to peak averaged 42 months. Indexes of S&P 500 total returns were rebased to 100 at the first month of each peak.
Sources: eVestment; Crandall, Pierce & Co.; analysis by PLANADVISER
The Yield Quandary
Sometime within the next few years, the swift and enormous support brought by the Fed and Treasury this year will restore jobs and commerce in the U.S. But interest rates may never be the same. Grant points to Powell’s vow that the Fed funds rate will hug zero for the next two years.
Oldroyd takes the idea a bit farther: “I’ve heard a prognostication that people in their 40s have probably seen the last Fed rate hike in their careers.”
Where do such returns leave investors in or near retirement, who by conventional wisdom are supposed to invest in the low volatility and generous income of bonds? At the end of June, U.S. corporate bonds rated AA were yielding just 1.6%. “The individual investor and his or her adviser face a pair of unusual, if not unique, risks,” says Grant. “One, the temptation to reach for yield presented by lawn-level interest rates. And two, the risk of a new inflation that is almost nowhere acknowledged, let alone discounted, in stock and bond prices.”
Managers are thus looking beyond the tried-and-true returns of investment-grade corporate bonds. “High-yield corporate debt has been one of our meaningful overweights” in the firm’s TDF and other multi-asset portfolios, says Vaselkiv. “We see that as a lower-risk way of playing some of the value sectors. You may not know where Ford common stock will be trading in five years, but, if you have a five-year Ford corporate bond, you should get your money back in 2025.” He notes that, at the end of June, bonds of companies rated BB were yielding about 5% and that high yield has evolved into a higher-quality asset class than it was 10 or 15 years ago.
“Because of negative real yields, TDF managers are back to raising their equity allocations, but that courts a fair amount of volatility,” Oldroyd says. “I think alternative assets—bond-like assets that are not bonds—will come into play more.” In fact, some of J.P. Morgan’s TDF configurations have included allocations to private real estate since 2005.
At Fidelity, Dierdorf incorporates high-yield corporates, as well as emerging market and floating-rate corporate debt, into TDF bond allocations. “But it’s just 2% or 3%, not the 10% or 15% that it might be when we would think there was tremendous value.” He also notes a higher allocation to TIPS: “Many of the policies in place now seem to be intended to create more inflation, and that’s a risk we feel might be undervalued in the market today.”
Art by Celia Jacobs