Market Update: March 30 – April 3, 2020 (US)

The economic damage comes through, the markets didn't have a huge reaction. 

The week ending April 3, 2020 saw equities fall 2.1%, as measured by the S&P 500. Investment grade credit declined by 9bps and high yield spreads increased by 21bps, ending the week at 266bps and 942bps respectively. The CBOE Volatility Index (VIX) fell significantly through the week ending, falling from the mid-60s last week and ending the week below 50. US government bond yields fell, two-year yields fell 1bps, 10-year yields fell 8bps, and 30-year yields fell 5bps. The US dollar rose 2.2%, measured by the DXY Index. All in all, a relatively calm week in markets.

The data were not so calm on the economic and health fronts. This week we continued to get an insight into how the labor market was affected by the stay-at-home orders issued across most of the world. At least 311 million Americans are under these orders, and the Federal guidance has been extended to at least April 30, 2020. The benefit of these orders is that it slows the spread of the virus and stops the health care system from being overwhelmed. The side effect is a crushing fall in
economic activity. All businesses are suffering, and as a result are shedding workers at an unprecedented rate.

What do we not know? What do we know?

There continues to be large and important facts that remain unknown, but this week we got some clarity, though from a small base, on some of these large questions:

1. How bad the pandemic is (due to a lack of testing). This week we saw the cases continue to rise across the US, and deaths continuing to rise, highlighting how far the virus made it into US society undetected. The latest models are predicting the peak in deaths to occur in April 16, 2020 and declining into May1. These projections are highly uncertain, at the peak deaths are expected to be 3,130 in a single day within a range of 1,282 to 7703. Crucially, these projections are based on maintaining social distancing.

2. How severe restrictions on economic activity will be. We are seeing that in order to curtail the virus spread restrictions will have to be severe. As an example, the unemployment rate is forecast to move into the double digits very soon. This is highly dependent on how long economic restrictions are maintained and how these unemployed people are technically counted in official statistics.

3. How long the restrictions will last.  We know this will be longer than initially expected. More States and countries are imposing restrictions. We expect the heaviest restrictions in the U.S. to last through at least mid-May, possibly longer. There will likely be a phaseback, with those returning to work first among people who are younger, in jobs more able to include social distance, or in areas less affected. Over time, we’ll see how effective that, combined with better testing and treatment, can keep the virus under control until there is a vaccine. That will impact the speed at which the economy is able to get back to full speed.

4. When the virus will stop spreading.  There are early indications social distancing is working, for example in Washington state, but this is the largest unknown and is the one with the most significance.

This is now being borne out in the numbers. 6.6 million Americans filed for unemployment benefits last week, and the much-watched non-farm payroll fell by 701 thousand jobs. Markets were unfazed by this; the numbers were expected to be bad. At a certain point there becomes a less impactful distinction between really bad and really, really bad economic news. Looking ahead the next piece of indigestion for markets may be the corporate earnings season, when we will begin to see the toll on US companies profits and expectations.

As reality has hit that this crisis may take many more weeks to move through, and that once the peak of the virus passes it will take time for the world to get back to work, attention is shifting to more fiscal support. There is already talk of further support measures, and this is something to watch closely in the coming weeks.

Although we know more than what we knew last week, we cannot stress enough that this remains and extremely uncertain situation, that will be driven by how the virus evolves. After all, we expect that tough choices will need to be made. What this means is that we all will continue to watch the data closely and become amateur epidemiologists. The truth is that we will know that when the fight is being won when the number of daily cases, followed by deaths begins to fall. For asset prices this means that valuations will continue to bake in significant risk premium to account for these uncertainties and could continue to be volatile moving forward.

Opportunities right now? 

Currently the environment is extremely volatile and fluid, which limits widespread opportunities and risk-taking. But some of our long-standing opportunities remain attractive, and new opportunities are surfacing.

First, the large drop in government bond yields means that some profit taking is warranted. We would be sellers of government debt to fund other opportunities.

Second, buying equities to move from underweight to target weight is appropriate. But we would not be moving back all the way to target immediately. A phased in approach is important.

Third, owning idiosyncratic strategies that capitalize on dislocations or attractive pricing remain interesting. Right now, these include bank capital relief, insurance-linked securities, and some event-driven and opportunistic credit strategies.

Fourth, the governance structure of institutional investors will influence how successful they are able to capitalize on the opportunities coming out of the dislocation. Having an “Opportunity Allocation” may be increasingly attractive. An Opportunity Allocation is not an investment in and of itself; rather, it is an asset category written into the investment policy statement to allow investments that don’t fit into other categories. It’s usually designed with a 0% target allocation and a maximum of 10%. Adding one to the investment policy could allow greater flexibility to pursue interesting opportunities.

What do we recommend right now? 

Corporate Defined Benefit Plans

For most defined benefit retirement plans, the market environment has led to funded status dropping. Consider the following to capitalize on the current and forthcoming environment.

  • Rebalance: Review your Investment Policy Statements to determine whether you should re-risk the glide path (i.e. increase the target allocation to return-seeking assets). Even if the Investment Policy Statement does not allow for re-risking the glide path, it may still be necessary to increase the actual allocation to return-seeking assets to get closer to an unchanged-target allocation.
  • Reduce duration: Investigate if the current ultra-low interest rate environment represents an opportunity to reduce the interest rate hedge ratio in order to improve funded status as interest rates rise. Current risks are skewed to higher rates, which benefits plans with unhedged interest rate risk.
  • Contributions: The stimulus bill (“CARES Act”) allows deferral of contributions due in calendar year 2020. Consider taking advantage of that.
  • Credit Exposure: Credit spreads have risen, and it is may be beneficial to consider rotating fixed income from government to credit.
  • Fixed Income Manager Guidelines: Review guidelines for active investment grade fixed income managers to reduce the need to become a forced seller of downgraded securities, as there is likely to be a wave downgrades in the coming months, and it may work to your advantage to not be a forced seller of these bonds. This could be relevant for many investor types, but it could be most important for corporate defined benefit plans with sizable allocations to liability-driven investment strategies.

Defined Contribution Plans

For sponsors of defined contribution retirement plans, times of market volatility often raise questions regarding what steps, if any, plan sponsors should be taking. Consider the following:

  • Plan Design: Consider whether your investment option lineup provides participants with ample flexibility to diversify in market downturns.
  • Administration: Verify that your administrative recordkeeper’s website and call centers are fully operational and not experiencing significant disruptions.
  • Regulatory Changes. Make sure your plan can administer the new rules in the stimulus bill, such as more flexibility for loans, early withdrawals, and required minimum distributions.

Non-Profit Investors

In addition to the market environment, many non-profit organizations are operating in extremely challenging environments now. Universities have shut down and moved to online learning, healthcare systems are on the front lines of preparing for the possibility of a mass influx of COVID-19 patients, foundations are responding to their grant recipients many who are already in very needy positions, and faith-based institutions have been asked to shutter for a while. We have some broad thoughts for the long term, total return asset pools (i.e. endowment, foundation, operating):

  • Enterprise Risk Management: Be mindful of all the different facets of potential liquidity squeeze across the portfolio and enterprise. At the portfolio level (i.e. private investment capital calls), at the market trading level, and at the enterprise level.
  • Governance: Stay the course towards the long-run goal and ensure the oversight procedures have built in flexibility to accommodate near-term disruptions in market and asset class relationships.
  • Opportunities: If you have ample liquidity, expect to see interesting opportunities in public and private markets.

Public

For public pension plans the recent market environment has shrunk asset values, particularly in publicly listed securities. For these plans we recommend the following actions.

  • Liquidity: Reviewing the amount of liquidity relative to the net cash outflows. Be cognizant of whether the economic environment will change the expected contributions, and how that could impact liquidity, particularly the relationship between public and private asset liquidity.
  • Opportunities: If you have ample liquidity, expect to see interesting opportunities in public and private markets.

Taft-Hartley

For Taft-Hartley Plans the recent market environment has shrunk asset values, particularly in publicly-listed securities. For these plans we recommend the following actions.

  • Liquidity: Add to liquidity buffers for pension plans to prepare for lower contributions. Individual plan circumstances should dictate how much, but perhaps doubling typical cash balance is a good rule of thumb.
  • Opportunities: If you have ample liquidity, expect to see interesting opportunities in public and private markets.

Health and Welfare

Health and welfare plans, which have wide variations in funding levels and sources.

  • Liquidity: Review whether to add a liquidity buffer, perhaps to prepare for lower contributions and/or increased cash outflow. Individual plan circumstances should apply.

Insurers

Insurers have faced a “double whammy” in this market environment. Equity and risk asset exposures will feel the sting of mark-to-market returns, and the historic drop in bond yields, a large source of insurer earnings will put pressures on profitability. The steps we recommend insurers take to capitalize on the environment going forward are:

  • Yield Enhancement: Some assets in the current environment have experienced sharp dislocations, particularly in fixed income markets, that may offer the opportunity to earn more from existing or new asset classes.
  • Program Guidelines: Review and benchmark guidelines to make sure the capture industry best practices.
  • Opportunities: Optimize the use of third-party managers who may be better placed to capitalize on market dislocations and opportunities that are appearing.

1 https://covid19.healthdata.org/projections
Market data sourced from Bloomberg. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass.
Information contained herein is for informational purposes only and should not be considered investment advice. 


Disclaimer

Index Definitions

  • U.S. dollar index (DXY) - is a measure of the value of the U.S. dollar relative to the value of a basket of currencies of the majority of the U.S.’s most significant trading partners.
  • VIX Index- Represents short-term expectations of investors regarding the market, using the implied or perceived volatilities of a range of stocks from the Standard & Poor’s 500 Index. The index is calculated from the number of “call” and “put” options present in a period.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Investment advice and consulting services provided by Aon Investments USA Inc. (Aon Investments). The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto.

This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on Aon Investments understanding of current laws and interpretation.

This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Investments preliminary analysis of publicly available information. The content of this document is made available on an “as is” basis, without warranty of any kind. Aon Investments disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Investments reserves all rights to the content of this document. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of Aon Investments.

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