INSIGHTS

Financial Industry Insights from Advisors Asset Management

Email
×
Email
×

AAM Viewpoints – Thinking at the Margins


A measure of caution and a measure of risk

It is easier to view the past with the benefit of hindsight than it is to determine the future through forethought. But, as challenging as the prior quarter has been, our purpose as an asset manager is to not only understand our prior returns but also look forward and make a fair-handed assessment of where we feel returns have the potential to be generated in the future. In various interviews and discussions in our commentaries and elsewhere, one core portfolio management philosophy of ours which should be clear is that we position assets where we are going, not where we have been. In that regard, while it may seem pithy, it is our opinion that we are nearer to the end of the massive interruption of economic activity than we are to the beginning. As a result, we feel a marginal increase in risk exposure presents an opportunity when coupled with a solid measure of caution.

While the economic effects of the global shutdown certainly show in the 1st release of Q1 (1st quarter) 2020 GDP, the adverse effects continued and accelerated into Q2. To be clear, there remains some ongoing uncertainty related to the risks particular to this pandemic. Will we find a vaccine? Will there be a second wave of cases this fall? Are cities, states, and countries putting themselves at high risk by opening too soon? Markets abhor uncertainty as much as nature abhors a vacuum. So, it is with a keen eye on the markets over the past few weeks where we witness an increasing confidence amid these uncertainties. To combat further risk to life and liberty, there is an unprecedented effort aimed at ensuring we have therapeutics to address the acute need of a medical intervention. Additionally, efforts aimed at “flattening the curve” appear to have reduced the likelihood of widespread infection in the near term. Without a doubt, there are epidemiological uncertainties which cause some medical experts to be concerned that a second wave of infections may be possible. However, while these uncertainties are possible, it appears clear from many of these same well-respected experts that they are not probable.

It is from this viewpoint and amid this uncertainty that some geographies are beginning to gradually reopen their economies. In our eyes, barring the risks detailed above, the rampant and near complete shutdown of economic activity will begin fading in the rearview mirror soon.

Rest assured, U.S. GDP in Q2 will be alarmingly low, but it will be another two months, late July, before we see the first estimate for the quarter. Employment, as we have seen in the weekly initial jobless claims releases of the prior weeks, will continue to be hard hit and the return to work for many of those unemployed will likely take many quarters. The result of an estimated 20% unemployment level will be that consumption for both businesses and households will suffer for a period. As a result of the nature of the pandemic, some businesses and business sectors could experience several quarters of tepid recovery. Certainly, there will be adjustments made in both personal lives and business practices, but what appears clear to us today is that economic activity in the U.S. will likely be historically low in Q2. As a result, the economic and human damage done will begin to be repaired in the coming quarters.

This outlook combined with a perceived bottom under the markets put in place by FOMC (Federal Open Market Committee) and U.S. Government intervention in March causes us to feel that adding incremental risk to a portfolio is a prudent and wise move when coupled with a core exposure of well-footed firms.

It is our opinion that a complete disregard for risk management is not justified by the interventionist tilt of the Federal Reserve and the U.S. Government. Rather, it suggests that in the coming months it is more prudent to add risk at the margins in an incremental manner while incrementally reducing exposure to safe-haven assets.

We are all familiar with the run to risk-free assets which occurs when economic uncertainty arises. The beneficiaries of this flight to quality are traditionally the U.S. dollar, Swiss franc, and Japanese yen denominated assets. It is the unwinding of these risk-off trades which we wish to begin to take advantage of.

Txy QTD and Prior

Source: ICE BofAML Indices | Past performance is not indicative of future results.

OAS Change

Source: ICE BofAML Indices | Past performance is not indicative of future results.

Above are two bar graphs of perhaps most familiar risk-off trade of the prior quarter. The flight into long U.S. Treasuries and the resulting effect on spreads. During Q1 2020, 10-year-plus maturity U.S. Treasuries experienced their second highest quarterly return since 1980 while spread to Treasuries widened to levels not seen since, in some cases, since the recession of 2007-2009.

Txy QTD and Prior

Source: ICE BofAML Indices | Past performance is not indicative of future results.

As a result, our baseline assessment begins with the bottom put in by the markets in late March following the robust actions of the U.S. Federal Reserve and the signing of the U.S. CARES (Coronavirus Aid, Relief, and Economic Security) Act. From this point, risk attractiveness improved as fixed income markets appeared to find a bottom while selected hard hit equity sectors began to recover. The attractiveness of selective risk exposure today continues as illustrated by the anemic performance of nominal treasuries thus far in Q2 and the tightening of spreads in selected high yield sectors.

OAS Change

Source: ICE BofAML Indices | Past performance is not indicative of future results.

Currency markets too have adopted a slightly more risk-focused posture. Since late March, the retracement of 50% of the decline in bellwether risk-oriented currency pairs – such as AUDJPY and CADCHF – illustrate positive reactions to central bank interventions, lower-rate targets, and the expected pickup in international economic activity as geographies begin to open gradually. Couple the rally in cyclical equities and fixed income with the strengthening of benchmark risk/on off currency pairs and our thesis of an improving economic outlook becomes more clear.

 

Australian Dollar/U.S. Dollar

Source: ICE BofAML Indices | Past performance is not indicative of future results.

While the nominal level of economic activity may take some time to recover, it is important to remember that equities, lower quality fixed income assets, and currencies of commodity-driven economies trade on the direction of the economy, not the level. In this regard, while keeping a wary eye on the uncertainties surrounding the pandemic, we will continue to communicate the importance of taking a slightly more risk-advantageous posture while reflecting on history to recall that periods of weaker performance are followed by periods of improvement. At the margins, it appears clear now to us that we may be in a period of undoing the damage which was necessary to avoid the damage which could have been done.

CRN: 2020-0511-8293 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

topics

×
2020 Investment Outlook
 

awarded Top 100 Wealth Management Blog

ABOUT THE AUTHOR
Author Image

Ask the Author

AAM wants to hear from you. Complete the form below to email the author with any questions or comments you may have. We understand that every firm handles interactive communications differently and will not post any feedback we receive without your consent.