Brian Herscovici, CFA, Chief Investment Officer, USAA Managed Portfolios
As our team sits down to recap the first quarter, we realize these are unprecedented time for citizens, financial markets, and USAA members investing through our USAA Managed Portfolios program. This is expected to be our last commentary for USAA; however, our service is not ending. Most of the team will be exchanging their USAA badge to join the Charles Schwab team. It has been a great privilege to work for USAA and serve our members. We are equally excited for our next chapter where we will continue this important responsibility and stand together with our members to ensure their financial security. As always, thank you for your membership and your service.
When the first quarter began you would have never imagined how it would have finished. As we entered the quarter, we completed a very successful year for investors and the first half of the quarter continued that trend. The US economy was on solid footing and we were seeing signs of an acceleration of growth in other regions, particularly in Europe. US/China trade dispute reached a partial settlement, the USMCA trade agreement was completed and most US investors were spending more time watching the Democratic Presidential primaries than thinking about what could go wrong, as evidenced by the S&P 500 hitting a new record high on February 19th of 3,386. In less than 30 days everything changed, the S&P crossed into bear market territory and the economy moved from growing to nearly full stop in unprecedented fashion. For the quarter, only the typical defensive asset classes of US Treasuries, Gold and the US Dollar have seen strong demand as investors shifted away from equities and credit markets.
As of 3/31/20
Unprecedented is probably the most common word when describing the current period, and it’s hard to say that it is unwarranted. Whether it is the speed, the impact or the reaction to the event, unprecedented fits for all. Record is another word that is being used quite often and we will probably hear more of it. Monetary and fiscal stimulus cannot cure a virus, but it is needed for markets to function normally and for the economy to resume activity. Central bankers are putting in a coordinated global effort to support the dislocation in markets with actions that are faster and larger than what we witnessed in the 2008-2009 financial crisis. There have been over 100 global central bank rate cuts and many are re-instituting Quantitative Easing (QE) programs used to stabilize markets in the previous crisis. Stabilizing liquidity in the credit markets has been a critical, and so far, successful, first step.
Unlike past periods where we saw events unfold over months, this happened in a matter of weeks. Paradoxically, the Great Recession of 08/09 might be helping us this time around as policy makers can reflect on what worked in the past and put it to good use confidently and quickly. With the action taken by the US Federal Reserve this month, the front end of the yield curve moved down over 150 basis points after two large rate reductions by the Fed. Additionally, the 10-Year Treasury hit a record intra-day low of 0.39% and closed at a record low 0.50% on March 9, 2020. The sharp reactions from the Fed were in response to both the corporate and municipal bond markets being hit by redemptions from mutual funds and corporate liquidity needs. Solvency concerns or a sell everything mentality led to a very sharp rise in credit spreads in March; however, as we closed the quarter, we were starting to see credit markets regain their footing but still reflect economic risk.
With monetary policy providing the critical first step to reassure financial markets, fiscal policy is the second step. Governments globally have been acting with resolve as they try to build an economic bridge to get us past an induced economic coma necessary to defeat the corona virus. Global leaders have made over 30 fiscal stimulus moves that total approximately 2.3% of global GDP, including the $2 Trillion US package signed into law this week. These swift actions are important as social distancing policies are having a dramatic impact on economic activity, especially in the service areas of the economy. The latest weekly jobless claims report shows the impact COVID-19 is having – 3.2 million claims in the last week of March alone is an all-time record that no one wishes was set. Jammed phone lines, inoperable websites, and more layoffs foreshadow the new 3.2 million record being short lived.
Two focuses of the stimulus package passed by Congress are small businesses and service areas within the economy. The intention is to provide aid that will allow these businesses to weather this storm and be able to move forward on the other side of this self imposed shut down of activity. Even with the legislation passed, implementation will take some time before the impacts will be seen and could lead to more negative economic data before potential improvement.
Commodities are another area of pressure for the market as the slowdown in economic activity has dampened the demand for products in which they are a critical input. While many commodities have seen prices react to the slowdown in demand for their end product, oil has seen the most impact. Oil is not only suffering from a sharp reduction in demand but also from Russian and Saudi Arabian leadership picking this moment to start a price war. OPEC plus Russia were operating under a production agreement that limited oil production through April 1, 2020. Those production cuts have not been renewed over a disagreement between the two major producers; in retaliation, Saudi ministers have vowed to increase production significantly once the production agreement expires. This has oil prices hovering near $20 as we close the quarter. This will put severe pressure on oil producing regions of the US and emerging markets, but consumers of oil will benefit from the lower prices of products like gasoline. Many producers have already started cutting their capital budgets and the rig count is coming down sharply but it will will take time to see a decline in US production. There will be a significant impact to earnings of energy related industries as well as some debt issuers in the space.
The markets were facing uncertainty from many fronts in mid-March. Fortunately the actions of central bankers seem to be relieving the liquidity strains from the credit markets. The fiscal stimulus is significant but the timing of restarting the economy is still a large unknown. For fixed income markets we expect to see an increase in defaults and credit downgrades but we believe the markets are now pricing in that risk. Equity markets have rallied in response to the monetary and fiscal stimulus but it is still facing a large unknown, the virus’s impact on earnings. With earnings uncertainty and speed of potential recovery unknown, we would not consider the equity markets “cheap” while trading near its average multiple. It is possible that the market bottomed on March 23 but typically bottoms are put in over a period of time. Only when new virus infections slow will we be able to see the light on the other side of this tragic event. Like the rest of the world, we hope that day is soon. A special thank you to medical professionals on the front line of this war.
Tactical Positioning in USAA Managed Portfolios was active during the quarter and at the end of the quarter was neutral stocks versus fixed income. Early in the quarter we moved to an overweight in equities by increasing our weight to small cap and reducing our exposure to emerging market debt. In mid-February we returned to a neutral stance with the addition of US Treasuries funded by a reduction in small caps. Our equity allocation remains focused on US large caps and international developed markets. We are avoiding EM equities as the risk-reward is currently better in developed markets.
Within fixed income, we emphasize higher quality bonds with a neutral stance to duration. As the support from the central bankers re-liquify the credit markets we should see credit spreads move back towards more normal levels. In addition to investment grade credit, we also increased our weight to cash late in the quarter as it provides a more favorable risk adjusted return relative to US Treasuries given the flatness of the yield curve and with record low yields (prices move inverse to yields).
At times of stress many investors feel the need to be reactive to the news. Many studies have shown that while market timing may relieve the impulsive stress it rarely provides a positive portfolio impact. What has proven to be a positive strategy is portfolio rebalancing using defined rules, not gut reaction. These are subtle shifts that may not be as apparent to our investors but have been done to realign portfolios back to target weights and take advantage of extreme moves. Earlier this year we rebalanced an overweight in equities that had developed with the strong equity returns in 2019. And in March we rebalanced our overweight in fixed income as equity markets fell.
As always, our guidance to members is to remain focused on the long-term investment plan that you have put so much thought into. For USAA Managed Portfolio members who may be uneasy about market risk in general or have concerns about current asset-class allocations, we suggest consulting with a USAA advisor.
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Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
Past performance is no guarantee of future results.
Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met.
Fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss. • Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. • The MSCI EAFE Index covers 21 developed markets outside of North America: Europe, Australasia and the Far East. It aims to include in its international indices 85% of the free float-adjusted market capitalization in each industry group within each country. • The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. equity market. The index covers approximately 85% of the free float-adjusted market capitalization in the U.S. • The MSCI World ex USA Index measure large- and mid-cap stock performance in 22 developed markets (U.S. excluded). The index covers approximately 85% of the free float-adjusted market capitalization in each country. • The Bloomberg Barclays U.S. Municipal Index covers the U.S. dollar-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. • The Bloomberg Barclays US Corporate High Yield Bond Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. • The Standard & Poor’s 500 Index is an unmanaged index of 500 stocks representing the large cap segment of the market, covering 75% of the U.S. equities market. • The S&P SmallCap 600 Index measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable. • The Russell 2000 Index is an unmanaged index that consists of the 2,000 smallest companies in the Russell 3000 Index. It is a widely recognized small cap index. • The Bloomberg Barclays U.S. Aggregate Bond Index is a widely recognized index used to track the performance of investment grade bonds in the U.S. • The Bloomberg Barclays U.S. Credit Index measures the performance of the investment-grade, taxable corporate and government-related bond market. It is composed of the Bloomberg Barclays U.S. Corporate Index and a non-corporate component that includes non-U.S. agency, sovereign, supranational and local authority bonds. • The JP Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for foreign currency-denominated, fixed-income securities issued in emerging markets.
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