Defensive but with an eye on opportunities

The full scale of coronavirus on economic activity is only beginning to become apparent, as lockdowns of significant portions of the global economy are the primary means employed to stem the virus’ spread. Eugene Philalithis, portfolio manager of the Fidelity Multi Asset Income range highlights some of the key investment tools they’re deploying across the range to mitigate some of the impact from markets. He also explains that whilst uncertainty abounds, for the discerning investor, there are opportunities to be found.

Key points:

• Selectivity is important, as is maintaining a significantly high position in the capital structure to preserve downside protection as this ‘crisis of time’ persists.
• We are focusing our attention on areas with attractive risk and return asymmetry.
• We don’t believe that the global economy and markets are out of the woods yet and are not willing to add to equity risk while the duration of this crisis is highly uncertain

The very weak economic data we saw in China during the depth of their economic shutdown is playing out in developed markets, and the worst weekly unemployment claim figures on record have hit the world’s largest economy, as the US is now the epicentre of the virus. But despite the obvious negative signs and seemingly inevitable recession, markets are whipsawing between focusing on the negative overall picture and historically significant monetary and fiscal stimulus, resulting in periods of selloffs and rallies. We don’t believe that the global economy and markets are out of the woods yet and are not willing to add to equity risk while the duration of this crisis is highly uncertain. We are seeing opportunities to shift some equity risk to areas with more attractive risk and return profiles, but selectivity is important, as is maintaining a significantly high position in the capital structure to preserve downside protection as this ‘crisis of time’ persists.

Speed and breadth of the shock is significant

The speed and breadth of this market shock has seen historically significant levels of volatility and meaningful sell-offs of major asset classes. It is difficult to overstate just how significant this statistical Black Swan period of volatility has been; drawdowns larger than Global Financial Crisis stress tests, and very high correlations between risky and safe-haven assets on the downside which limited the benefits of traditional sources of diversification.

The strategy has drawn down year-to-date, but this was mitigated by its defensive positioning entering this market environment, with our regional and sector equity hedges contributing positively. The UK government bond allocation performed well year-to-date, and we have closed the position last month to take profits here, as well as maintaining a high overall allocation to defensive assets. Other positions helping to minimise downside participation were our hedges on emerging markets local currency exposure, and the relatively low level of high yield exposure relative to the strategy’s history and regional bias towards Asia high yield. The asset class has not been immune from this period of market stress, but it continues to perform better than the US and European high yield markets, while offering attractive coupons that help cushion some of the price volatility. There is a risk that bond defaults may pick up, but we expect the Asian market to do better than the US market if this takes place, given the US market’s large exposure to energy and retail companies.

Focusing in on risk and return asymmetry

Given the continued uncertainty facing markets, as well as significant trading costs as liquidity has tightened, we are not making large directional bets at this stage. But as with any periods of volatility, let alone one this extreme, opportunities and dislocations are beginning to emerge. We are focusing our attention on areas with attractive risk and return asymmetry. One example of this is a shift from Master Limited Partnerships (MLPs) into US dollar denominated emerging markets debt. In recent years, the composition of the emerging markets hard currency universe has evolved to include a higher allocation to oil exporting countries, and this has resulted in a more meaningful oil beta than in the past. MLPs also have a high oil beta, and both assets have corrected meaningfully during the recent oil selloff, but we see emerging markets hard currency debt offering mean reversion qualities, better downside protection, as well as upside participation when the oil price eventually recovers.

Where are the opportunities?

We are also seeing value begin to emerge in corporate bonds as spreads have widened meaningfully. While we think the barrier to adding US high yield is quite high at present, we have higher conviction in the prospects for US investment grade fixed income. We have seen significant indiscriminate selling that has led to more attractive valuations, and this selloff has hit even those corporates with strong balance sheets and cashflows. Many companies are facing or will be facing significant threats to cashflow sustainability, and dividend cuts are to be expected in such an environment, but this does not necessarily mean poor management decisions or a business in decline as in normal circumstances. That said, given our cautious approach and broad mandate, we prefer to gain exposure to those quality businesses higher up their capital structure, and it is worth remembering that bondholders are always paid first. Until we see a meaningful turnaround in the economic backdrop, our preference is likely to remain for debt over equity securities. The strategy is also holding one of its highest ever levels in cash, which includes an allocation to money market securities and shorter dated corporate bonds. This offers low risk and high liquidity, as well as sacrificing less yield than holding outright cash or many developed market government bonds.

These things take time

It is likely to be some time before we know the scale of economic damage of the polices taken to stem the spread of the virus, or if the very large fiscal responses globally will be enough. When the growth rate of the virus slows, we will be looking to short term money markets, safe-haven currencies and commodity prices for signs of stabilisation. We are not seeing that yet. While market volatility remains elevated, we prefer to closely monitor developments and remain cautious, while incrementally adding to areas of conviction offering strong risk-adjusted returns.

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Important information

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Multi Asset funds use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments in overseas markets, changes in currency exchange rates may affect the value of an investment. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in small and emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document and annual and semi-annual reports, free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority and by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0420/31061/SSO/NA

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