Investment Weekly Market Update 2020 (US)

Trade Tension Resurface

Over the week ending May 15, equities fell by 2.6%, as measured by the S&P 500 price index. Investment grade credit spreads fell 3bps, ending the week at 196bps, and high yield credit spreads increased by 32bps, ending the week at 750bps. The CBOE Volatility Index (VIX) fell, increased by 4%, ending the week at 32%. Two-year yields, 10-year yields, and 30-year yields fell by 1bps, 5bps, and 7bps respectively. The US dollar strengthened by 0.7%, measured by the DXY Index. 

Economic News

This week we saw a number of economic releases that gave further insight into the damage racking up in the economy - unfortunately more records were broken.

Unemployment claims continued to increase, this week a further 3 million people filed for unemployment benefits. The total now stands at 36.5 million. Other major economic news released this week included CPI inflation, retail sales, and industrial production.

Inflation fell across the board in April's release. Headline inflation fell to 0.3% p.a. from 1.5% p.a. in March. The dramatic fall was a consequence of the collapse in energy prices. Looking through to core inflation, which exludes volatile food and energy prices, price growth fell to 1.4% p.a. from 2.1% p.a. in March. The fall in inflation reinforces that a deflationary shock remains a large risk to economies right now. Retail sales collapsed over April by 16.4%, the most since data began to be collected in 1992. The same records and trends held true when we stripped out automobiles and gas, as these core sales fell by 16.2% through April. The record-breaking fall in retail sales highlights just how far consumer purchasing has fallen.

The collapse in demand has, as expected, rippled through to the manufacturing sector. Industrial production for April fell by 11.2%. This was the largest fall in industrial production since records began 101 years ago. Looking ahead, economy watchers are beginning to turn to high frequency data, such as restaurant bookings and mobility data, in attempting to gauge how fast consumers return to the world.

Market Developments

Equity markets continued their trend of oscillating between weekly gains and losses, and this week the bears won. The S&P 500 suffered its biggest weekly decline since the middle March. The stock market has now been firmly stuck in a range for the last 3 weeks. The negative sentiment this week was driven mostly by resurgence of trade tensions between the US and China. Trade tensions have risen through the week, first with President Trump indicating that he had no interesting in communicating with President Xi Jinping on trade talks. Then later in the week, the administration imposed additional trade sanctions on Huawei Technologies (a leading technology company in China), further limiting its ability to import US technology. The tensions have increased as the US administration has attempted to shift the national focus from COVID-19 at home to China. The meaning of all of this is that at a time when markets remain in search of direction, this is a reminder that the economic tensions preCOVID remain in play.

COVID-19 Developments

Curves continued their trend of decreasing or holding steady across the developed world as social distancing remained in place. Worryingly, across the emerging world, cases are increasing - Brazil and Russia have reported large new case counts. Emerging countries are lagging the developed world because COVID-19 arrived later in the year, social distancing is harder in densely populated countries, few have the luxury of working from home, government safety nets are not as strong, and increased testing is uncovering more cases. As long as some parts of the world have a significant number of cases, we believe that travel restrictions will remain in place to some degree, having consequences on the economic recovery.

In the US more states continued on their journey to reopening. Now only a handful of states remain completely shut down; most state have reopened or partially reopened with guidance on social distancing. An early mover in the US was Georgia, which was the first state to begin reopening from April 24th. Georgia has not seen a large spike in cases since its reopening, giving some hope that re openings can be successful. It remains to be seen if cases in Georgia remain suppressed and if the re-opening will lead to a sustained move higher in activity.

To facilitate the reopening of state economies, one large piece is testing to be able to detect outbreaks of the virus quickly and contain them. There are two main types of tests to discover current viral infection, the established PCR test, and the newer antigen tests. The difference between the two tests is time to get results and accuracy, the PCR tests being slower but more accurate, against a faster, less accurate, antigen test. The hope is that antigen tests can be used to rapidly screen the population with test results given in a few minutes to identify those who require further screening. The idea being that the faster you can test, the more confidence you can have in the ability to contain outbreaks. So far there is one FDA approved antigen test available but more research is being done. 

Investment Opportunities right now?

  • 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 where appropriate and gains have accrued.
  • Recent market strength means that we are recommending only rebalancing to the lower end of the allowable policy range for equities if you are below the lower end of your investment policy. For investors already within their allowable policy ranges, we are advocating a wait and see approach to buying more equities. This does not imply an expectation that large market falls are necessarily imminent, but that market levels suggest inferior rewards for taking equity risk. 
  • Owning idiosyncratic strategies that capitalize on dislocations or attractive pricing remain interesting. Right now, we are seeing the most opportunities in opportunistic credit strategies, such as TALF 2.0 strategies and other strategies that focus on the dislocations that occurred in credit markets. Other opportunities include insurance-linked securities, distressed debt, and some event-driven strategies.
  • 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. Evaluate how it might impact your organization. 
  •  Credit Exposure: Credit spreads have risen, and it 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:

  • Administration: Monitor your recordkeeper’s call center average wait time and call abandonment rate and review against any service-level agreements you may have in place with your recordkeeper.
  • Participant Communication: Ensure your employees know about webcasts and additional digital content available to help answer their questions.
  • Additional Participant Communication: Leverage your recordkeeper’s education and communication program and resources to keep participants apprised of savings and investment considerations. Some plan sponsors are considering sending special communications to their participants rather than just making sure their recordkeepers communicate sufficiently.
  • Participant Behavior: Understand how your employees are reacting by reviewing your recordkeepers’ reports on participant activity around deferral changes, loans, and withdrawals. Consider whether participant behavior— either disengagement or market timing—warrants longer term consideration of reenrollment into the QDIA.
  • Regulatory Changes: Work with your consultant, recordkeeper, and legal counsel to determine what provisions of the CARES Act you want to adopt for your plan, including if any provisions that were not originally implemented should be in the future. Consider whether any provisions require an opt-out versus opt-in approach by your recordkeeper.

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 faithbased 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 are facing the impacts of both historically low rates and volatile equity markets. Equity mark-to-market return volatility will be reflected in net income, 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:

  • Stress Testing and Scenario Modeling: AM Best announced stress-testing certain insurers to gauge the COVID-19 impact on risk-adjusted capital levels, investments and reserve adequacy. Aon’s SnAP tool allows us to run iterations of investment allocation decisions and model the impact on insurer financial metrics and ratios.
  • Liquidity: FHLB rates are at historic lows. For insurers with ample liquidity, this is an opportunity consider managers that can help insurers take advantage of interest rate arbitrage by borrowing at low rates and investing in higher yielding high quality securities. For investors with lessor liquidity, consider increasing capacity to meet unpredictable cash flow needs.
  • 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. 

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

S&P 500 Price Index (SPX) - A capitalization-weighted index representing stocks chosen by Standard & Poor’s, Inc. for their size, liquidity, stability and industry group representation. The companies in the S&P 500 Index are generally among the largest in their industries.
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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