Note Précis March 6, 2020 – Best of Times and Worst of Times : The DJIA has dropped precipitously while swinging by several hundred points a day in late February/early March 2020. This behavior has scarcely been an exception among equity markets, worldwide. On a best of times and worst of times basis, it is appropriate to consider the role of risk premiums. This facet also applies to now ultra- low fixed income yields, not least on momentum. However, credit risk in sovereign and corporate issues alike seems elevated. In many ways we see as a red herring, claims that risk is binary and therefore hard for markets to incorporate. It is an art, not science even amid a plethora of data.
Risk premiums are not about being clairvoyant on specific risk, such as Covid-19, but more about recognizing that unknowns do and have flared in the history of finance. We see these aspects as having driven Benjamin Graham in the valuation of securities in the late 1930s on and driven Paul Volker in the exercise of central banking in the late 1970s onward. Modern markets and authorities may be mistaking the plethora and volume of data with accuracy in assessing impact. We believe markets now to y be re-calibrating their erstwhile excess focus on central bank policy as a driver mitigating risk.
Capital market volatility will likely remain high for economic and political reasons. Equity markets may be closer to fair value but are still not inexpensive, recent pullbacks not withstanding. Psychologically, the presence of despair is still absent as is the stripping out of excessive euphoria that has often marked a meaningful bottom amid business change. We would look for better balance between value and momentum market tactics. In business, it involves changes in logistics by companies by more investment into more diversification of manufacturing. It would mean better market performance in the business of industrials compared to the long dated prior cycle leadership of consumer areas in emerging and advanced economies alike. Financials are likely to be crucial components in the markets which is would likely to continue recalibration of their asset standards. It probably would mean still further casualties among the weakest financials as currently being seen in Europe and Asia. It would also mean greater risk premiums being attributed to junk bonds This would likely also means stress amongst those portfolios that stretched for yield in this cycle such as via leveraged finance instruments. Even if the present fears of the impact of Covid-19 are excessive, further central bank easing may be politically necessary but its efficacy is likely suspect.
We espouse diversification including above benchmark cash and precious metals. Currency volatility remains a risk to consider, despite having been latent in the G-7 era of ultra-low administered rates. As well, a quality balance sheet and business tilt seems appropriate across sectors and in geographic allocations in capital market holdings.