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How well did diversification protect investors during the crisis?
Yves Bonzon: “In early March, as announcements of containment measures and border closures followed one another on both sides of the Atlantic, a tsunami hit the financial markets. US equities suffered their fastest drop in history, losing -35% on the S&P500 Index in three weeks. Perhaps surprisingly, the worst hit area of capital markets turned out to be credit rather than equity markets, heavily impacted by forced asset sales and liquidations. Credit suffered from severe illiquidity issues at the peak of the market turmoil, the possibility to trade at even half a decent price and in size was virtually non-existent. Meanwhile, with the exception of US Treasuries, safe-haven bonds did not perform either so far since the beginning of 2020. While crypto assets have miserably failed their first real acid test, gold rallied lately, but it did so to a lesser extent in the very beginning of the crisis, as systemic risk remained under control and interest rates could not keep going further down. As a result, it is indeed the strategic diversification of a portfolio that best protects against the effects of such shocks, as opposed to shorter-term tactical measures.”

Are you changing strategic asset allocation weightings in any way following the crisis?
“At the end of the first quarter, we made a conscious decision not to mechanically rebalance our portfolios towards their strategic allocations, keeping that option for later. The road ahead was expected to remain volatile. In equities, we therefore maintained the bias towards quality and growth companies that had served us well so far. In the emerging markets fixed income area, we continued to prefer hard currency instruments, refraining from investments in their local currency counterparts. As far as the emerging markets equity allocation is concerned, we stick to our concentrated bet on China, which we prefer as a country with the ability to support and stimulate its economy in adverse conditions.”

What assumptions about the economy and capital markets underly any changes?
“The current crisis and its impact on financial markets has significantly altered the long-term expected returns for different asset classes. While our expected returns were relatively low across the board at the end of last year, a crash in the price of risky assets has improved their risk premia. We estimate that the crisis will reduce corporate earnings by 20%–30%, but we foresee a catch-up over 10 years and forecast a return to average corporate earnings and valuations within 10 years. This has led us to add 2% to our expected annual risk premium, now expecting world equities to return 1% more each year over 10 years from current levels than we had anticipated at the end of 2019. US government bonds, however, are expected to yield 1% less going forward. The yield on government debt fell significantly, following the US Federal Reserve’s adoption of its zero-interest-rate policy to combat the adverse effects of Covid-19. 

“In conclusion, the efficient frontier is now steeper, particularly in US dollar, making the relative attractiveness of risky assets over risk-free assets higher. In other words, the expected payout per unit of risk should be higher looking forward.”

Do you think that investors will change their approach to diversification and asset allocation in any fundamental ways in future?
With the Fed holding rates at zero for a very long period of time, there is no alternative to diversified investments. Fed Chairman Powell promised to raise interest rates only after full employment is restored, which could take several years. The outlook for lower rates for longer is not only supportive from a valuation perspective, but also means that an enormous amount of money parked in money market funds could be channeled back into higher-yielding instruments such as bonds and equities. Holding cash will not be rewarded for a very long period of time, and I strongly reiterate the call to view the strategic asset allocation, and not cash, as the true benchmark in a world of explicit financial repression.”

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