Governments will struggle to get their economies back up and running if they fail to bring coronavirus under control, according to JP Morgan Asset Management’s Mike Bell, who says the pandemic is challenging traditional portfolio construction. 
Bell (pictured), global market strategist at JP Morgan Asset Management, said the impact of Covid-19 has made it difficult to construct portfolios with traditional asset classes such as government bonds and equities.
“Two years ago, you could have bought a 10-year US Treasury in the knowledge that we were late in the economic cycle and when a recession eventually took place, the Fed would cut interest rates down to zero,” he said.
“And you would have made a handsome return on your Treasury bonds as yields fell sharply. The problem, of course, is that that story’s played out.
“It’s a similar story elsewhere in the world, like in the UK: they’re now low-income investments with low potential returns over the coming years.”
Bell said this means government bonds, which in the past were useful for income and diversification, are now being much less attractive than they used to be.
“And so, as I see it, the most clear asset allocation call is to be underweight government bonds,” he added.
However, the uncertainty in both the economic outlook and for the virus makes it difficult to be overweight risk assets such as equities or credit, he noted.
As such, Bell said JP Morgan Asset Management has been adding the protection it traditionally gained from government bonds through macro hedge funds.
“If you’re underweighting government bonds, as seems to make sense at the moment, you want to be looking to add the kind of strategy that puts the hedge in hedge funds,” he said.
Source: JP Morgan Asset Management
Bell said, historically, macro hedge funds have done a very good job of protecting portfolios when equity markets fall, with the HFRI Macro index – an index measuring the performance of a broad range of the strategies – outperforming the FTSE All Share during more volatile periods, as the chart above shows.
“One of the criticisms levelled against macro funds over the last decade has been that whilst they did a very good job of protecting during bear markets, on average, they haven’t produced a particularly attractive return during bull markets,” he added, noting the table on the right” he added.
“From late 2009 until the end of last year, macro funds on average were actually the [worst] performing asset class within the hedge fund space during the bull market.”
While traditional hedge funds might be beyond the grasp of retail investors, Bell said there are liquid alternative strategies that would be available to investors.
An underweight in government bonds does not mean that Bell thinks investors should be overweight in risk assets such as equities, however. The outlook for the asset class remains unclear with several risks on the horizon.
“The vaccine is the biggest reason to avoid underweight positions in risk assets because you could get caught off-guard by a sudden announcement,” he said. “We also just don’t know when there will be more fiscal stimulus and we’ve seen since March what that can do to markets.”
As such, Bell said it makes sense to continue focusing on quality companies with strong balance sheets that will be able to survive even if the pandemic lasts another 12 months or more.
“There are some cheap companies at the moment, which are cheap because if the vaccine doesn’t come along soon, they’re going to go bust,” he explained. “So, focusing on quality matters, but within that also avoiding overpaying for stocks.
“Certainly, it seems to me that when you look within markets there have been or there are signs of irrational exuberance coming through particularly in some of the growth stocks, and particularly in the US.”
Bell said the market rebound – as demonstrated by the S&P 500 – has been “extraordinary” in historical terms but has been deceptive.
Performance of S&P 500 since 23 March
Source: FE Analytics
“If you look at the S&P 500, it looks like the market has priced in a V-shaped economic recovery. Whereas in fact, if you look beneath the surface of the market, that’s not really what’s happened with all the huge dispersion in sector returns that’s going on beneath the stock market,” he explained.
Such dispersion at a sub-sector level has led the index to look as it if it close to where it was pre-Covid-19 and give investors hope that some of the beaten-up stocks could be picked up at bargain prices.
“Just because you’re down 50 per cent it doesn’t mean that you can’t go down more and, obviously, into administration,” the strategist said.
“So, we have a preference for quality companies first, avoiding the ones that are going to be at risk of bankruptcy in the event of a continuation of the virus.”
Furthermore, the valuation gap between quality-growth and value stocks that was reasonably consistent between 2007 and 2016 has widened significantly.
“Some of those growth stocks are great businesses, but obviously there comes a price at which a great business is not a great investment,” he added. “And I think you’re certainly starting to see some signs of irrational exuberance going on within some of those growth stocks at the moment.
“So, we would avoid an overweight to them.”
Nevertheless, Bell argued that quality stocks can continue to outperform until there is positive news on a Covid-19 vaccine.
With many developed markets exiting lockdown as infection rates and deaths continue to come down, Bell warned that there are parts of the world where coronavirus is still not under control.
And while Covid-19 continues to impact economies it remains difficult to foresee any economic improvement, the strategist said.
“The only way to deal with a virus-driven recession is to get the virus under control,” he explained. “And whilst we’ve seen governments and central banks providing life support for the economy, the Fed and the government can’t print vaccines, which is what’s really needed.
“You need to get the health problem under control in order for the economy to function.”
As such, all the fiscal stimulus that has been put into the economy now will need to continue as the economy operates under a more challenging environment than ever before.
“What we’ve seen is that fiscal stimulus has supported incomes and allowed households to pay their debts, but if the fiscal stimulus is turned off before the virus is beaten then there’s a risk that the economy will relapse into a double-dip recession in the economies where the virus is still a problem,” he added.