Much has already been written on the implications of market events in the last couple of years, which might be described as a substantial performance divergence in Indian equities between few index heavyweights vs. rest of the broad index composition – driven mainly by the risk-averse sentiment amid slowing global and local economy.
In the last few months (before the Covid-19 outbreak), market sentiment was seeing a mild recovery on the back of fiscal and monetary measures announced by the Indian government and central bank. At the start of 2020, markets could be described as a cocktail of high market valuations, and strong momentum/positive sentiment mixed briskly with the impact of surprise, uncertainty, and hard to quantify risk in a world that is ever more connected both via travel and supply chains.
What resulted post the Covid-19 outbreak was one of the fastest drawdowns from peak levels, to leave most stock markets with a correction of around 20% and rising bond prices as money flowed to government bonds and safehaven assets – reflecting at best a global slowdown.
How were we positioned in early February?
In our multi-asset managed portfolios, we were conservatively positioned to minimize drawdown before the sell-off, which acted as expected to cushion the impact somewhat of a vicious recent sell-off: We were overweight domestic bonds, particularly short & medium term and cash and underweight equities, particularly India and U.S., relative to the benchmarks or neutral allocation.
As a group, we aim to build portfolios that deliver returns through the cycle in a much steadier way and with less drawdown than a broad composite benchmark. This is designed to help investors with risk-adjusted returns equal to or above benchmarks and dilute the negative impact of human emotion at times of market drawdown, such as the one last week.
What happened during February and thereon?
Market reaction displayed all stages of analysis typified by Howard Marks as level one and level two thinking.
Level one analysis: Earlier in the month, the news was spreading of Covid-19 virus (aka the “novel coronavirus”) being found outside China, with Korea, Iran, and Italy having the most infections. At this point, European and Asian markets went into heavy losses with travel, airline, and tourism stocks most badly hit based on demand implications.
Level two analysis: Then kicked in as markets began to accept that lower movement of people and goods was going to result in disrupted supply chains for many of the goods that are manufactured in the United States and other developed economies. This led to the markets falling hard based on supply-cycle considerations.
Later, the attention turned to what the policy response might be. Both monetary policy and fiscal policy are important levers in the toolkits now for governments, especially given monetary policy is potentially out of ammunition. Monetary and fiscal policy stimulus measures have been announced by most of the affected countries, barring India, although the RBI remains open to provide further monetary support.
How are we reacting?
As the virus inevitably spreads, the extent of its impact on the global and domestic economy remains to be seen. We expect the investor fear quotient to reduce from markets, and instead, prices to focus on earnings impacts. When that attention turns there, we would expect very different results from those companies that have been able to keep their supply chains intact versus those who have not.
Now we are focused on rebalancing portfolios back to target (selling bonds and buying equities) in order to respond prudently to recent market actions. Along with this, we are reviewing the magnitude of the underweight stance on Indian equities and overweight stance on debt.
Our estimated 10-year valuation implied return for Indian equities – with the recent drawdowns see improvement from a valuation standpoint. Return expectations from fixed income have come off relative to what they were a couple of months ago as yields fell across the curve. With the return profile improving for Indian equities, we would, in high probability, increase allocation to equities (thereby reducing our underweight positions) by utilizing extra cash and debt allocations.
Wrapping it up
Market volatility is normal but nonetheless unsettling. The third and fourth quarters of 2018, less than 17 months ago, were when the Indian equities fell by 16%. Steep market drawdowns are expected to be most severe when select pockets are trading at high valuations, as was the case in mid-January this year.
Rebalancing is our usual practice after large price movements to maintain the target asset allocations in our portfolios. The recent price moves have caused us to rebalance our portfolios by selling cash/debt and buying local equities.
We are assessing buying opportunities brought on by the declines and would follow our valuation-driven asset allocation approach in evaluating our underweight stance on local equities.
