Friday, April 3rd, 2020

One Disease; Three Themes

There is no big theme to the note this week. The world already has one and financial markets are as clueless as everyone one else at predicting the short and long-term consequences of Covid 19. So, this is just an assembly of ideas which arise from our regular reports.

Our first chart is an update on our all-asset volatility index. This has now risen to 281% – meaning that the realised volatility of our basket of 11 financial assets is 2.81 times its median over the last 25 years. It has taken five weeks to get to this level from its previous undisturbed state. The jump is now bigger and faster than the onset of the global financial crisis, which took nine weeks to develop, from late August to the end of October 2008. The period of elevated volatility then lasted another four months before our index finally topped out at 393% in March 2009.

Unless a miracle cure is announced in the next few weeks, we expect our index to match the peak of 2008, which implies another period of elevated volatility, lasting for the whole of the second quarter at least. We actually believe that the probability of a miracle cure is higher than most of the mainstream media realise, but the risk-reward ratio for taking this position is still not attractive.

Our second chart highlights an equity sector strategy which we believe will be effective in both up and down markets. Our tactical asset allocation models are close to maximum underweight in global equities, but most of our clients are obliged to maintain some exposure. They may be reluctant to give up all hope of a rally in the near future. We suggest that they should overweight Technology and underweight Energy in all regions. We note that Technology is outperforming while equities are falling and we believe that it will at least perform in line if they start to rally. On the flipside, Energy continues to underperform on the way down and we remain sceptical that it would outperform on the way up – especially if investors look at the trade on a risk-adjusted basis. Most regions also have a significant overweight position in Healthcare and underweight in Financials, but this is far more sensitive to market direction, which is why we prefer the Technology/Energy trade.

And finally, we focus on country allocation, with specific reference to Emerging Markets. The first thing to say is that the charts are all over the place. There is a group of countries which have languished at the bottom of the table for many months which are suddenly rallying and there are several from the top half which are starting to underperform. There are many more emerging markets in the first group than the second, which has the effect of increasing our exposure to EM Equities.

Some commentators take the view that these countries have more fragile economies than developed markets and are bound to suffer worse, but many of the examples they cite are from countries which are currently classified as frontier markets, which we do not include in our models. We cannot be certain that EM Equities will escape the effects of this terrible disease, but we prefer to be guided by our models rather than a priori assumptions. If we have to be contrarian, we will do it on a country, not a sector, basis.

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