AAs we entered 2020, many investors (PIMCO included) expected a moderate recovery in the global economy and believed that asset prices could follow suit. In fact, some investors were pivoting towards a ‘risk on’ posture as they considered their asset allocation. This seemed perfectly rational given the outlook for growth in the major developed markets looked reasonable and central banks remained accommodative. Geopolitics was viewed as the most likely source of uncertainty and risk.
The outbreak, and spread, of coronavirus, which is a tragic humanitarian event for all those impacted, has added unforeseen uncertainty to the economic outlook, particularly given the importance of China to global growth and its integration into global supply chains. While nobody knows how long this global health crisis will last and exactly what the economic and financial market implications are likely to be, we believe that judicious portfolio positioning can help protect investors’ portfolios in this period of heightened uncertainty (and even help them prepare for opportunities).
Assessing the impact on Asian markets
Given the uncertainty of the current environment and the extent of global disruption, we expect central banks to adopt a risk management bias and tendency toward dovish policies, especially within Asia. We believe that this uncertainty could lead to a range of outcomes that may not be easy to predict.
The key for us will be to observe how quickly China and Asian economies can rebound following Q1 (assuming the virus is under control by then) toward trend growth and how much lost ground they can make up. There is the potential for lasting structural change in Asian industries – for example, with the rise of online economies, potential supply chain migration and redundancies. Certain sectors, such as airlines and travel, will take longer to recover given the hit to consumer confidence. This will lead to market dispersion and require careful industry and issuer selection to select the best investment opportunities.
The recent increase in the spread of the virus outside China has affected equity valuations, with the U.S. S&P 500 Index experiencing a sharp correction on 24 February after making a historical high earlier in the month. This has had a knock-on effect on other stock markets around the globe. Spreads on developed market credit have widened in the last few days but remain near the tight end of recent history, partly due to expectations for further central bank accommodation, while Asian credit spreads are at narrower levels compared with the initial knee-jerk widening in early February.
Keep a close focus on liquidity risk management
In our latest Cyclical Outlook, “Seven Macro Themes for 2020,” we noted that the baseline outlook for 2020 looked positive, but we recognized that risk premia had been compressed by central bank action, leaving little cushion in the event of a disruption such as we are currently seeing. In addition to being relatively light in taking top-down macro risk in portfolios and careful scaling our investment positions, we believe it prudent to keep a close focus on liquidity management and be cautious on generic credit.
A lack of market liquidity tends to exacerbate stress events. We believe it’s prudent to hold sufficient highly liquid assets to meet potential redemption requests and collateral or margin call needs. If investors keep enough “dry powder” on hand to wait for opportunities to arise, they may be able to take advantage of potential market dislocations and exploit liquidity premiums.
Being sufficiently liquid today does not guarantee that a portfolio will be liquid next week. While the maintenance of a prudently calibrated liquid asset buffer directly addresses potential needs for portfolio liquidity, it is not sufficient when liquidity conditions change. Rigorous, active portfolio management is required to manage the risks of shifting markets and liquidity challenges.
We are committed to managing downside portfolio risk through a rigorous process aimed at damping volatility and enhancing returns, especially during periods of stress. While having to maintain a sufficient buffer of liquid assets may at times detract from the ability to allocate to assets with the highest potential returns but potentially lower liquidity, this trade-off can sometimes be minimized by employing derivatives. Notably, the liquidity in an individual derivative may improve in periods of market stress, as demand for liquid hedges increases. While – like all investments – derivatives are not without risks, we believe that when used properly and prudently, derivatives have an essential role to play in managing portfolio risk, and particularly liquidity risk.
Be cautious on generic credit
Credit market valuations look tight and there are some signs of excess in certain credit sectors. We remain concerned about market structure in credit and the growth of corporate issuance and investor allocation to credit, in contrast to the decline in market liquidity for corporate bonds. In the event of a significant shift in the demand for credit or an overall rise in market volatility, we are concerned about the market’s capacity to facilitate large-scale risk transfer without big price movements. Within credit, we expect to favor financials over industrials.
We have been reducing generic credit exposure for some time. Caution on credit now means that we expect to be well prepared to take advantage of select opportunities as they arise and to be liquidity providers – not liquidity demanders – with the ability to add credit risk in the event of corporate credit market dislocation.
Take advantage of opportunities as they arise
As we pointed out in our 2019 Secular Outlook, investors will have to get used to “dealing with disruption” and position their portfolios accordingly. Events such as a global health crisis create uncertainty in markets, but careful portfolio construction and credit selection can help to protect investors during such periods, and sometimes take advantage of market dislocations.
As active managers, we find the ability to respond to market stress and exploit liquidity premiums can be a fundamental driver of positive returns, and the ongoing management of portfolio liquidity risk is key to being able to take advantage of those opportunities.
Stephen Chang is a portfolio manager based in PIMCO’s Hong Kong office.