As all of you know, the coronavirus continues to be front and center in the news and on the minds of many of us. I would like to take this time to walk through how we use a disciplined approach to address issues such as these.
It is important to understand that mitigating risk is the primary focus of what we do whether it be portfolio construction, financial planning, taxes, etc. There are many risks that we take into consideration, including the fact that unknown events will arise from time to time. Part of this mitigation process is modeling potential impacts of these unknown events using historical data, which we do on a regular basis. We are confident that this focus on only taking risk for which we are getting paid, in the long-term, is the correct approach.
Many of you were with us during the great recession in 2008-2009. We used this same disciplined approach to reduce risk, walk through the geopolitical turmoil of the time, and even strategically pick up equities at some very attractive prices when fear was still in the markets. Equity and fixed income markets can and do react irrationally when unknown events arise creating great uncertainty. We have seen this fear of the unknown show up in spades this week.
When we design our portfolios, we build them using a diversified mix of equities and fixed income which is designed to provide returns while mitigating risk. This design may take shape within weeks, months, or even years in advance for changing market and economic cycles. Besides our focus on using fixed income to help offset equity risks, here are a few examples of this design which you may not even be aware:
- We have been underweight international equities for years because the U.S. has had a more robust economy, which has benefited the portfolios even during the most recent volatility.
- We have intentionally held dollar-denominated foreign fixed income to take advantage of what we saw as an environment conducive to a rising dollar against other currencies.
- As we were writing almost 2 years ago, we did not see a high probability of an economic downturn in 2019, which turned out to be a great year for the stock market, despite other firms who called for a recession. Our strategic decision on this also benefited our portfolios.
Looking forward, we are beginning to see signs of economic activity improve in China e.g., Starbucks announcing they are reopening most of their stores there. This helps us model the future as we project how the life cycle of this event will play out. This also helps us in taking advantage of market volatility to pick up equities at cheaper prices – just like buying items when they go on sale at the store. Certainly, the slowing of manufacturing in China will impact our projections of economic growth in U.S. because of the supply chain interruption. Because of this, we believe this cycle will take a little longer to work out (a “U” shaped recovery) as opposed to the very quick recoveries in more recent years that we have witnessed when markets have retreated (a “V” shaped recovery). In no way do we expect this event to bring about the type of deep volatility we saw in 2008-2009.
In review, I see these types of pullbacks as opportunities to take advantage of market volatility as I believe this too will pass. In addition, the design of the portfolios, with fixed income allocations, allow us to weather these types of events with less downside risk than would otherwise be the case. This also gives us “ammunition” to take advantage of market declines. You may see us adjusting the portfolios for just this purpose.
One editorial comment if I may: I have long been a critic of just-in-time production which has led to a global supply chain that is concentrated in mainly a few areas on the globe. A vast amount of this concentration is in China. I am hopeful that companies will reassess these practices and adjust to create more resilient supply chains that are not as concentrated. To note, our representatives in congress, on both sides of the aisle, are looking to introduce bills that would reduce our reliance on the Chinese medical supply chain as most prescription drugs sold in the United States are manufactured in China – something you may not be aware of.
As always, we are here working on your behalf and we appreciate your trust. If you have any questions please let us know.
Marc E. Henn, CFP