Macro matters


Why investors should take advantage of the second chance to protect their portfolios from volatility

Lara Rhame
June 12, 2020 | 4 minute read

How often do you get a do-over in life (off the golf course)? And yet investors today are facing that very opportunity. We can all be pardoned for not seeing the pandemic coming, but right now it’s hard to craft an excuse for failing to make necessary changes to better insulate our portfolios from volatility against the backdrop of continued economic weakness. Thursday’s acute sell-off is a visceral reminder that uncertainty regarding reopening, the nascent economic recovery and the pandemic are all challenges that investors still need to navigate.

2020 has offered markets a wild ride. As the pandemic crashed upon U.S. shores, financial markets fell into a bear market in just 16 trading days. The S&P 500 lost 34% of its value in just 5 weeks, with volatility exceeding the turbulence of the financial crisis in 2009. Aggressive Fed policy action helped calm the most acute volatility. This included slashing interest rates to zero and providing “unlimited” quantitative easing, which in just a few months has added $3 trillion to the Fed’s balance sheet, almost doubling its size.

This extraordinary intervention was surely instrumental in fueling the recovery in equity prices. And recover they did! From the low on March 23, equities have steadily marched higher. As of Monday, June 8, the S&P 500 was up 0.05% for the year, just 4.5% below its February 19 high. Indeed, outside of the black swan event of the pandemic, the effortless recovery of the equity markets is probably one of the most unexpected outcomes of 2020.

But if equity prices have returned to, or close to, their pre-COVID levels, valuations and underlying fundamentals look entirely different. The economy is now in recession. We are experiencing an epic dislocation in employment with 21 million people newly out of work,1 dwarfing job losses of any recession in living memory. We are staring down a Q2 contraction in activity that could be between -20% and -35%, the worst since WWII. Yet P/E ratios (the ratio of price to estimated earnings over the next 12 months) have skyrocketed. At the start of 2020, valuations were slightly above their long-run average. Now, at 25.5x, valuations are in the top decile. We haven’t seen this level of exuberance since the 1999 tech bubble.

The connection between markets and investor goals can change rapidly. An InvestmentNews study conducted in August/September 2019 showed that investors’ three main priorities were protection from losses (62%), generating income (56%) and diversification of investments (54%).2 That was before the heart-stopping volatility of February – before the recession, widespread job losses and a health crisis that continues to pose significant uncertainty on our communities and households. It is fair to say that if these were investor priorities in late-2019, a period marked by low volatility and broadly strong market performance, the urgency around these priorities has most likely grown significantly.

This brings us to the mulligan. Equity prices are (almost) back to where they began 2020, and fixed income has benefited from significant price gains. Advisors get to come up with their “2020 plan” all over again. To fully take advantage of the mulligan, you reevaluate the landscape and reach for a different golf club. The broad market recovery is an important opportunity to reexamine risk tolerance and find ways to insulate portfolios from potential future bouts of volatility.

Thursday, June 11, delivered a painful reminder of the devastating impact of volatility. The S&P 500 dove 5.9% and the Dow shed 1,800 points. The catalyst was ostensibly the Fed’s economic projections, which showed a sharp decline in GDP in 2020, and high unemployment that could linger well beyond 2021. However, this was not new news to most economists who have been warning that reopening and a strong recovery are two very different prospects.

News that COVID-19 cases are on the rise as states reopen is also troubling, and speaks to the fact that at its core, this is really a health crisis that has caused an economic downturn. Unfortunately, the arc of our nascent recovery continues to be heavily influenced by how the pandemic evolves. This is a stark reminder that uncertainty is far from retreating.

Finally, for investors who can take this moment to reevaluate their portfolios, it is critical to realize that the interest rate landscape has been radically altered, perhaps for years to come. U.S. Treasury yields have plunged, with the 10-year down from over 2.00% just a year ago to around 0.70% now. Traditional fixed income vehicles are, for all intents and purposes, offering significant duration risk for virtually no income. Generating income – the second most important investor goal – not only remains top of mind but has become increasingly difficult. Asset classes, like high yield, that had perhaps held a more peripheral place in the portfolio could well deserve fresh consideration.

The financial market recovery of the last several months has been an enormous positive for households as wealth has been rebuilt. This will help support our economic recovery and reinforce the optimism that is starting to spread with reopening. Investors should not pass up this opportunity to reevaluate their priorities and choose investments that can offer better insulation against future volatility and bolster their income going forward.

  • Continuing claims were 20,929,000 in the week ending May 30, 2020.

  • “Reframing the role of alternatives,” InvestmentNews, January 21, 2020.

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Lara Rhame

Chief U.S. Economist + Managing Director

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