ASI: The coronavirus crisis – how should long-term investors respond?

May 25, 2020

There comes a time in deep bear markets when investors are terrified of economic catastrophe, and the valuations of risk assets become extraordinarily cheap. Markets find their bottom, in part, because brave, long-term strategic investors start to re-enter the market. They are normally richly rewarded for doing so.

For investors who bought the US S&P 500 Index in the depths of the 2008/09 financial crisis, the subsequent annualised 10-year return was 15.2%.[1] Of course, it’s difficult to allocate to equities when the talk is all of economic meltdown. After all, markets that have fallen 30% can still fall another 50% or more. But the point will come when – and we will get to the 'when’ question later – long-term investors should be willing to take these risks, accepting the possibility of short-term losses in favour of the rich long-term rewards as the economy gradually gets back on its feet.

The value of strategic asset allocation

Strategic asset allocation (SAA) can be helpful in providing investors with a structured valuation-driven framework to make these difficult decisions. It does so by encouraging a disciplined rotation of capital through the cycle. When times are good, investors complacent and markets expensive, SAA reduces exposure to risk. When times are bad, investors fearful and market prices cheap, SAA recommends increasing exposure.

Equity valuations outside of the US are now far below 15-year averages on standard valuation multiples. For the US, this valuation difference is less marked. Valuation multiples go haywire in recessions, as their denominators (e.g. forward earnings) fall faster than prices. However, long-term discounted cashflow valuations also show substantial cheapening across markets. It seems clear that the premium offered by risk assets over government bonds is much larger now than it was in our pre-Covid-19 forecast. In that forecast, the combination of expensive equities, together with elevated recession risk, led us to suggest a somewhat cautious portfolio. This had less exposure to equities and more to emerging market debt and corporate bonds.

At the time of writing, with the S&P 500 at around 2,400, adding weight to equities – and especially non-US equities – starts to look worthwhile for long-term investors. But this not an easy decision. There are some important questions to consider. How bad will the economic damage be? When estimating returns, we have to take account of the permanent loss of capital: some companies will default and others will be forced to repair their balance sheets by raising new capital, thereby diluting their shareholders.

Lockdowns designed to suppress spread of the virus are having a severe immediate effect, with some forecasts of a quarterly decline in US output of 24% in Q2.[2] We don’t know how long these lockdowns will last. China and South Korea offer some hope. In different ways, their ‘no-holds barred’ approaches have shown that it’s possible to begin the journey to some kind of normality within weeks. But it’s not yet clear whether Western countries will be as effective at supressing the virus. Our lockdowns are less complete than China’s and, with some partial exceptions, the West is not yet testing and tracing cases on Korea’s industrial scale. The longer lockdowns persist, the worse the economic damage. And, while the economic situation in China and Korea is improving, it is still very depressed compared to normal.

Policymakers respond

The extraordinary fiscal and monetary policy we are seeing will mitigate the damage. However, it’s not yet clear the extent to which it can prevent large-scale unemployment and business failures, and the cascade of further economic and financial challenges. Our latest economic forecasts have downgraded global growth to -8% in 2020. This is about three times the size of the decline recorded in 2009 in the wake of the great finance crisis. We are expecting one or two quarters of very deep contraction in a broad range of economies, followed by a strong rebound in late 2020 onwards, with global growth jumping in 2021 perhaps by double digits from this low baseline. Though we now assume a permanent reduction of GDP by 3%. In our asset-class forecasts, we assume significant permanent damage, with bankruptcies and defaults subtracting capital at roughly the same level as during the financial crisis.

For example, default losses in the US high-yield sector reached a cumulative 9%, while UK equity dilution was 8%.[3] But, even with these fairly severe assumptions, over the long term, the impairment caused by the recession is much more than offset by the rebound in valuations to their long-term averages. If this year’s recession were to turn into a deep and more protracted slump, the gains from the eventual valuation rebound will be smaller, and a desirable entry point pushed further into the future. Nevertheless, the rewards for taking equity risk will still be attractive.

Regime shift?

Another important consideration is the possibility that the structural investment ‘regime’ may shift. Since the financial crisis, we have been stuck in a world with very low interest rates, chronically weak demand and an absence of inflationary pressure. The profound shock created by the global pandemic and economy-wide lockdowns, together with the fiscal and monetary policy response, may be so significant that it may herald a change in the long-term structural outlook. This could go in one of two opposite directions.

The protracted lockdowns and an ineffective policy response could result in a period of deep global deleveraging and a deflationary slump. Alternatively, a combination of unprecedented fiscal policy combined with massive central bank action may result in a shift to significantly higher inflation. Our base-case view is that, post-crisis, we will return to the current low interest rate, low inflation regime. But the two tail risks – deflation and inflation – are now much more likely.

This creates a big dilemma for strategic portfolio allocation. A more inflationary environment will suit equities. But, with yields near zero and the return of inflation, nominal bonds will no longer be a useful component of portfolios. The hunt will be on for alternative sources of diversification – precious metals, commodities and real assets like infrastructure. By contrast, a deflationary slump will likely lead to mediocre returns for equities but will make fixed-income corporate bonds more attractive, particularly if spreads remain elevated. As the crisis progresses, we will be able to form a clearer judgement of probabilities. It is likely that a nimble approach to managing investors’ SAA risk profile will be needed.