Fears of the coronavirus outbreak and its economic toll have triggered drastic market moves in recent weeks. As a result, the composition of many portfolios has shifted away from what it has supposed to be on a broad asset class level. Sharp equity selloffs and government bond yield declines have mechanically turned many portfolios underweight equities and overweight bonds – compared with their broad asset allocation benchmarks. We favor re-balancing toward benchmark weights, but recognize that timing and implementation will vary by investor.
Many investors re-balance portfolios back toward strategic benchmarks on a calendar basis. Yet extreme market moves have likely caused their portfolios to drift dramatically from benchmarks. We illustrate with a hypothetical portfolio of 60% developed market equities and 40% global bonds. Over the past month, the weight of equities in the portfolio would have rapidly shrunk to just over 50% due to a sharp equity selloff. This one-month drift has been sharper than that seen during the 2008 crisis. See the chart above. We still see benchmark weights as appropriate. This implies a need to re-balance portfolios – effectively buying equities and selling bonds. To be sure, we believe it is too soon to overweight equities. As we await signs coronavirus infections are peaking and decisive policy actions are stabilizing the economy and markets, it may be prudent to start leaning against market moves through re-balancing. The right time to do so will vary by investor and should take into account considerations such as transaction costs and market liquidity.
The coronavirus outbreak represents a major external shock to the macro outlook, akin to a large-scale natural disaster. Public health measures deployed to stop the virus’ spread are set to bring economic activity to a near standstill and cause a sharp contraction in economic growth in the second quarter. But we expect activity to ultimately return with limited permanent damage as long as authorities deliver an overwhelming fiscal and monetary policy response to bridge businesses and households through the shock.
The required policy response includes drastic public health measures to stem the outbreak – and a decisive, preemptive and coordinated policy response to stabilize economic conditions and financial markets. All this is starting to take shape. Central banks have cut rates and adopted measures to ensure markets keep functioning. The key here is to alleviate any dysfunction of market pricing and tightening of financial conditions. What is needed are overwhelming and coordinated policies – both on monetary and fiscal fronts – that forestall any cash-flow crunches, especially among small businesses and households, that could lead to financial stresses and tip the economy into a crisis, as we detail in Time for policy to go direct. The UK, Canada and Australia have served as models of policy coordination, as we have advocated in Dealing with the next downturn. We expect a third, significantly larger, fiscal package to emerge soon in the U.S. – likely reaching $1 trillion, or 5% of GDP – although there may be twists and turns as it makes its way through Congress.
We maintain benchmark weight in equities, credit, government bonds and cash, but have updated our granular asset allocation views for the next six to 12 months. We emphasize geographies with the most policy space – such as the U.S. and China in both equities and credit, and favor quality exposures. We upgrade U.S. equities because of their quality bias and expected support from fiscal stimulus. We downgrade Japanese equities because of the limited monetary and fiscal policy space to offset the outbreak’s impact. In fixed income, we reduce Treasury Inflation-Protected Securities (TIPS) to neutral after a huge decline in rates, though we still see value in the long term. We upgrade euro area peripheral government bonds to neutral after the recent spread widening and an expectation that measures by the European Central Bank will keep yields low in southern-tier countries. For long-term investors, significant value has been created in risk assets.