February 2020 Macro Commentary
Global Reflation Interrupted by Coronavirus….
Fundamentals now being impacted
Review of Portfolio Positioning
By Sanjay Khindri, CFA
Our expectation going into 2020 was for still subdued global growth in the first quarter, but leading economic indicators were pointing to a stronger 2020 second-half for economies outside of the U.S. Global inventory normalization and a rebound in Asian demand was also expected to provide support for the earnings of more cyclical stocks. Implied future Eurozone short-terms rates and global PMI’s (business surveys) were rising and equities followed-suit, albeit with valuations ahead of fundamentals as indicated in our January 2020 Commentary. The backdrop implied steeper yield curves, a weaker U.S. dollar and better equity performance from cyclical sub-sectors.
This momentum has been temporarily upended by the spread of the Covid-19 virus. The virus has shown to spread easily with a range of severity, making it difficult to predict the ultimate global economic impact. While new daily cases in mainland China have stabilized, new cases outside of China are accelerating. When the virus first surfaced, quality growth and yield-oriented U.S. stocks were safe-havens, keeping U.S. equity volatility relatively low and strengthening the U.S. dollar. Now, risk-aversion has spread causing a spike in volatility and negative performance from U.S. consumer and growth stocks. It is hard to contemplate easier monetary policy supporting economic activity in this situation: supply and demand has been impacted by a shock that is exogenous to the regular flow of credit. In the near-term, the markets will have to grapple with this reality so long as the ultimate impacts of the virus remain very uncertain.
Because it has been a while since we’ve seen the magnitude of equity market drawdowns experienced in February, it is helpful to review the recent performance of various portfolio diversifiers, or hedges. The table below shows the percentage performance of four typical equity hedges since January 21, 2020: 1) the S&P 500 Volatility Index (VIX); 2) A 10-year U.S. Treasury ETF; 3) the USD-JPY exchange rate (price of 1 U.S. dollar in terms of Yen); and 4) the price of Gold in U.S. dollars (proxied by the GLD ETF).
Source: Gallatin Capital Management, LLC
Volatility has clearly been the best hedge, as one would expect, but the rapidity of the rise particularly stands-out. We believe this partly represents an unwind of short-volatility positioning put on by traders during the 4th quarter of 2019. While we think VIX will remain at an elevated level, any incremental hedging gains here will be limited. The 10-year U.S. Treasury has predictably provided negative correlation compared to equities; but in order to realize the magnitude of returns that 10-year Treasuries have historically provided when equity returns are negative, the 10-year Treasury yield would have to go close-to or below zero (see table below).
Source: Gallatin Capital Management, LLC
This is certainly possible if the virus outbreak gets much worse, but the overall risk reward of passively holding duration (i.e. interest rate sensitivity) is relatively poor in our view (see our December 2019 Market Commentary).
Gains from selling U.S. dollars and buying yen have been relatively muted. This is because the virus is having a material impact on the Japanese economy. That being said, Yen remains an attractive tail-risk (i.e. worst-case outcome) hedge as it remains the primary funding currency for global financial assets.
Up until the last trading day of February, the price of gold had returned 6.5% since January 21. On February 28th, however, the price dropped over 4% as investors sold gold to meet margin calls on other assets. Importantly, we think this time is different for gold when compared to the global financial crisis. In 2008/09, there was a global liquidity crisis due to an over-leveraged banking system which drastically increased the demand for paper currency and reserves. Those same negative liquidity conditions are not present today. We think gold can continue to be a viable portfolio diversifier over the near and intermediate-term given: 1) gold’s valuation compared to the level of the U.S. monetary base, and 2) the outlook for sustained negative short-term real rates, irrespective of the virus impact. That being said, a positive shift in risk sentiment could cause a temporary meaningful reversal in the price of gold.
The point of summarizing the performance and outlook of these portfolio diversifiers is to highlight that we believe portfolio risk management should not be static: it is a dynamic process where hedges are evaluated just like any other investment, on the merits of risk, reward and valuation. We think this is one area where even passive investors can add value to their portfolios.
Review of Portfolio Positioning
At Gallatin, our portfolio allocation going into 2020 was a balance of trying to capture cyclical global economic upside while managing the risk of overvalued asset prices. We were holding a meaningful amount of cash but knew what stocks we wanted to buy when valuations became more attractive. The equity exposure we did have was higher beta, but we held what we believed were cheap hedges against that exposure.
As the market has drawn down meaningfully from its highs, we have gradually closed-out certain hedges; but we are still hesitant to begin deploying cash. While the S&P 500 is now down 12% from its highs, we have to remember that the market was overvalued to begin with compared to fundamentals (see our January 2020 Market Commentary). Even if we assume zero S&P 500 earnings growth for 2020, down from the 7% expectation, the market is still trading at a higher-than-average historical multiple. When one then considers the worst-case scenario of the virus outbreak, it is hard to get comfortable deploying meaningful amounts of cash. The virus situation at this point is too uncertain and fluid, and so objective risk management calls for evaluating worst-case outcomes.
We will approach this situation as follows: 1) we have begun small rebalancing in our portfolios to manage exposure to companies with more leveraged balance sheets in order to guard against a more prolonged economic slowdown, and 2) we are double-checking our theses, valuation targets and risk factors on our buy-list names so we can be ready to quickly deploy excess cash as the situations evolves.
Please feel free to reach out with any questions, to receive prior month’s market commentaries or to learn more about Gallatin’s strategies and portfolio solutions.
Gallatin Capital Management, LLC
Important Disclaimer: This material is for your information only and is not intended to be redistributed or used by anyone other than you. The information contained herein should not be regarded as an offer to sell or a solicitation of an offer to buy any financial products. This material, including any investment recommendations herein, is intended only to facilitate discussions with Gallatin Capital Management as to its investment offerings and strategies. The given material is subject to change and is not guaranteed as to accuracy or completeness and it should not be relied upon as such. The material is not intended to be used as a general guide to investing, or as a source of any specific recommendations.