Optimizing Asset Allocations Amid Multidimensional Uncertainty

The impact of COVID-19 on world markets and investors has been unprecedented. Challenges have arisen on numerous fronts, including oil price wars and geopolitical anxieties—all in addition to difficult questions about the progression of the virus and assessments of the associated economic fallout. As a result, investors are operating in an environment characterized by multidimensional uncertainty.

Such uncertainty is fueling huge swings in asset prices, both in terms of absolute magnitude and speed. As markets try to determine the impacts of COVID-19, fundamentals are lagging behind and analysts are struggling to pinpoint the effects on different industries and companies, as evidenced by the record-high dispersion around earnings estimates.¹

Confidence is key—where will it come from?
In the face of such uncertainty, confidence becomes key. For confidence to emerge, three key elements must come together:

1. Progress in treating the health crisis – This includes scaled-up testing solutions and contact-tracing programs in the near term, followed by therapeutic treatments and ultimately, a successful vaccine.
2. An appropriate level of policy response – It’s time to dust off the global financial crisis playbook. Policy response is critical, and in the midst of a crisis, it’s better to have too much than too little. Worldwide, we have already seen a large amount of monetary and fiscal stimulus, but it’s too soon to know if it will be effective. Results won’t be immediately apparent, so patience is required.
3. Clarity around the economic situation – Growth figures for Q2 2020 are widely expected to be weak, and many economies around the world are poised to enter recessions. Our economics team expects the US to contract at a 15% annualized rate in Q2—but that isn’t as dire as it sounds. If our efforts to limit the health crisis to a peak of three to four months are successful, the US economy may be able to begin gradually reopening in mid-May. This would allow growth to return in Q3 and Q4, setting the stage for above-average growth in 2021. The reasonable strength of the economy heading into the crisis combined with the amount of stimulus and deferred demand gives us confidence that this clarity will come.

Implications for tactical active asset allocation
We entered March with an overweight to risk assets, including US large-cap, European, emerging market, and REIT equities along with high yield bonds and broad commodities. As part of our investment process, we utilize the Market Regime Indicator (MRI), which seeks to measure investor risk sentiment, which has an impact on driving the market environments. The MRI is composed of three forward-looking market inputs: equity-implied volatility, currency-implied volatility, and credit spreads on risky debt. Taken together, these forward-looking factors help us to correctly identify the prevailing market risk environment, which helps us to adopt the best asset mix to protect and build portfolio returns. The MRI has five regime classifications, ranging from euphoria (extreme risk appetite, i.e., greed and complacency) to crisis (extreme risk aversion, i.e., fear and panic).

In late February, the MRI crossed into the crisis regime, where it remains today. Being in a crisis regime is a contrarian indicator; however, in the current environment, we recognize that the issues facing the markets are not related to a typical economic slowdown. Taking the MRI reading into account alongside our investment team’s judgment, we remained overweight to growth assets but did reposition for March by de-risking the overall portfolio. Exposures to European equities, high yield bonds and commodities were reduced, while exposures to investment-grade bonds, cash and gold were increased. Our rationale for these moves was based on our prediction that, while Q2 will be painful, a recovery will materialize in Q3 and Q4. In addition, we believe that the recovery will be supported by significant monetary and fiscal policy. We felt a modest de-risking was prudent but did not want to sell en masse into weakness. We maintained this positioning over the course of March and rebalanced at month-end by selling bonds and repositioning into equities.

When our team met again in early April, it was interesting to observe that, despite all the interim volatility, the S&P 500® Index had declined just 0.44% since our March meeting.² At the April meeting, we decided to maintain our position in growth assets, favoring US large caps and emerging market equities. We also looked to add a modest increase in risk by purchasing intermediate-term investment-grade corporate bonds. To fund this, we sold REITs, broad exposure to US investment-grade bonds (“Agg” exposure) and cash.

Our rationale has several components. First, the MRI continues to indicate that we are in a crisis regime, although to a lesser extreme than before. This contrarian signal would suggest that adding risk and purchasing intermediate-term investment-grade credit was our first step in that direction. Bond valuations look attractive, given our view that Q3 and Q4 will deliver a rebound in economic growth. Additionally, our models are forecasting spread tightening after credit spreads recently widened significantly to levels not seen since the global financial crisis.³ Lastly, the Federal Reserve is acting as a supportive force, directing quantitative measures to this segment.

On the sale side, REITs have become less attractive because of leverage and financing concerns along with uncertainty around the implications of long-term social distancing. Broad exposure to US investment-grade bonds has become less attractive due to valuations of government bonds, and with interest rates near 0%, cash is also less attractive.

Looking ahead with cautious optimism
Getting more clarity around the health crisis—in terms of reaching a plateau in the number of cases and fatalities—and making progress toward medical solutions are critical steps in moving forward. Investors need to be able to confidently assess value, which will be driven by more clarity on earnings and improvements in sentiment readings, such as the MRI. Finally, investors need confidence in the ability to transact. Central banks have taken steps to shore up this confidence, and we expect these actions to continue. As difficult-to-digest data from Q2 begins to roll out, markets will potentially feel further pressure, making confidence in the ability to transact increasingly important.

This is a challenging time for investors, as uncertainty is not well received by markets. There will be tough days and weeks as the world navigates this crisis, but we are cautiously optimistic. According to the old adage, in times of crisis, markets often take a “fire, ready, aim” approach. Investors who avoid this temptation and take the time to aim will be positioned to navigate uncertainty.

For more insights into our model portfolios, visit our ETF Model Portfolios page.