Stocks have lost more than 30% from the highs in a matter of weeks during the coronavirus epidemic, marking the fastest end of a bull market on record (link to Monday’s blog post). Oil prices have fallen 65% to under US$25/barrel since the beginning of the year, and the VIX (a measure of equity volatility) has spent many days this week above 70 (it had been holding in the teens for much of the past year). Even precious metals, like gold, which are often thought of as good hedges in times of crisis, have witnessed sharp declines in recent weeks as investors favor less risk and more liquidity in the form of cash (see Chart 1).
Asset performance, year-to-date 2020
Cash has its place in a portfolio and is a viable tool for helping to protect principal while also remaining invested and diversified. Assuming a recovery will be swift but difficult to time, many investors prefer to look through the volatility and remain invested. They may still have large capital gains even after recent losses and may be reluctant to trim those positions. Either way, for those investors who still have exposure to stocks and other risky assets and who are looking to lessen the losses in their portfolio, we have three strategies to share: unhedged currency exposure in global stocks, quality and minimum volatility factor exposures within equities, and government bonds.
Unhedged exposure to global stocks
We’ve long suggested that investors systematically hold unhedged positions in global stocks not because of an expected decline in the Canadian dollar versus world currencies, but because the Loonie tends to exhibit highly pro-cyclical behavior that has proved especially beneficial during selloffs. The Loonie has proven especially vulnerable during the current crisis because of the one-two punch of low oil prices sparked by the price war between Russia and Saudi Arabia and a broader hit to economic activity caused by coronavirus containment measures.
In the latest selloff since the weekend of January 20 when China first confirmed human-to-human transfer of the coronavirus, Canadian investors with hedged currency exposures have experienced the full extent of the losses in foreign markets, such as losing more than 25% in U.S. stocks. Unhedged exposures would have produced a substantial loss, too, but the U.S. dollar appreciation would have lessened the loss to the high teens (see Chart 2). Ultimately, unhedged exposures, which ironically contain some currency risk, produce lower volatility in global equities compared with hedged exposures (see Chart 3, right side). With the Loonie below US$0.70, a tactical hedge might make sense when the number of new coronavirus cases peaks. Meanwhile for bonds, the currency volatility overwhelms the volatility in interest rates, suggesting a hedged exposure makes more sense (see Chart 3, left side).
Hedged and unhedged equity returns since January 20, 2020
Unhedged and hedged volatility from a Canadian investor’s perspective, 2000-2020
Defensive equity style factors
In our tactical asset allocation framework, we focus on four equity style factors: momentum, value, quality and minimum volatility (see our latest factor update here). These last two – quality (companies with sound balance sheets) and minimum volatility (companies that have historically exhibited lower volatility) – tend to perform best during periods of either slow economic growth, like the period that prevailed prior to the coronavirus outbreak, or during a contraction in activity like now. We’re overweight both positions in our factor exposure framework.
In fact, minimum volatility and quality have outperformed the broad equity market in both absolute and risk-adjusted terms since January 20 (see Chart 4). Public health measures deployed to stop the virus’s spread are set to bring economic activity to a near standstill. This mechanically could translate into a global recession this year, defined by two quarters of negative GDP growth. But activity should eventually return rapidly with little permanent damage, provided both fiscal and monetary policy actions are taken to support businesses and households through the shock. Importantly, we are also underweight value (cheap stocks relative to fundamentals), which has lagged the broad markets and all other factor exposures, both well before and after the coronavirus appeared on the scene in mid-January.
Information ratios of equity style factors, 2020
Discussion of giant fiscal stimulus packages arriving within weeks to the tune of 4-5% of GDP in many countries may be putting some upward pressure on longer maturity bonds, as investors price in higher expected issuance and potentially firming inflation once the crisis passes. Moreover, the diversification properties of government bonds may be losing some of their potency with yields near their lower bounds. For now, however, Canadian government bonds have provided ballast and delivered uncorrelated and positive returns through the coronavirus shock (see Chart 5). We would also expect any upward moves in bond yields to be limited by the efforts of global central banks to expand their balance sheets, as the Fed, the BoJ and others have announced in recent days.
Ultimately, investors that are weathering this storm and not abandoning ship will face volatility and are still exposed to potential losses as the coronavirus infection rate rises in many countries. These three strategies may help cushion the blow until it becomes more apparent that it’s time to raise exposure to risk assets.
Correlation of Canadian stock and bond returns, 2000-2020
Kurt Reiman is a Managing Director and BlackRock’s Chief Investment Strategist for Canada. Kurt is a regular contributor to The Blog in Canada.
Daniel Donato is an Associate within BlackRock’s Toronto office.