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Crisis, Interrupted? Taking Stock of a Drawdown That Hasn’t Stuck

Alexander Paulsen photo

Alexander Paulsen

Director of Research (emeritus)

Five months into one of the most volatile periods since the 2008 financial crisis, global capital markets have proven resilient—but investors are still wary.

Global capital markets rapidly adjusted to new realities in 2020. The onset of a global pandemic drove an organic drawdown, dimming economic forecasts and stoking investor fears. Next we entered a stabilization phase as governments and monetary authorities intervened. Months later we can take stock of how various global capital market segments have responded to the recent volatility through drawdown analysis, traditional valuation metrics, and direct observation of these developments through the eyes of retail investors.

Our first step is to sift through key fixed income and equity market indexes. Leading asset class benchmarks provide peak drawdown/recovery progress and helpful valuation metrics. Morningstar’s Closed-end Fund Category Average Indexes afford a view of individual investor behaviors by asset class. Although each has a narrow story to tell, the overall picture may yet surprise.

Moving out the curve offers potentially higher taxable equivalent yields

Sources: Bloomberg, Parametric, 8/31/2020. For illustrative purposes only. Not a recommendation to buy or sell any security. US agg bond measured by Bloomberg Barclays US Agg Index, municipal bonds measured by Bloomberg Barclays Municipal Bond Index, US equity measured by S&P 500®, world ex-US equity measured by MSCI World ex USA Net Index, and emerging markets equity measured by MSCI Emerging Markets Net Index. Calculations reported by Bloomberg.

As we would have expected from a sudden and acute shock, peak drawdowns were most pronounced in equities and the more spread-sensitive bond segments. Unexpectedly wild gyrations in US Treasury yields and within higher-quality fixed income segments also posted surprisingly deep yet short-lived drawdowns. By the end of August, remaining drawdowns narrowed to single-digit levels while aggregate bond indexes fully recovered. Select valuation metrics set the 2020 results within a historical context.

Moving out the curve offers potentially higher taxable equivalent yields

Sources: Bloomberg, Parametric, 8/31/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.


Current income with capital appreciation

Despite the ongoing global health crisis, broad swaths of the fixed income market—except for munis—have retreated toward median valuation levels from the last 20 years. Relative to US Treasuries, 10-year AAA muni yields remain in the most attractive historical decile, with 5- and 30-year maturities similarly situated. Although absolute municipal bond yields are thin, Treasury yields are thinner. The global earnings shock has left the US equity in the richest decile and developed equities outside the US are in the richest quartile. Only emerging-market equity segments show signs of value, with PE ratios approaching the bottom quartile. The speed and breadth of the recent recovery, aided by an ocean of fiscal and monetary stimulus, have largely erased most signs of the ongoing crisis.

For an idea of how investors are responding to recent volatility, we can look at closed-end funds (CEFs) investing in each asset class. CEFs are launched via an IPO process to invest in specific investment strategies, typically segregated by asset-class focus. Once listed, investors trade at the prevailing market prices instead of at net asset values (NAVs). Unlike open-ended mutual funds or ETFs with fair-value or NAV-based pricing mechanisms, CEF market prices generally drift away from NAVs, offering either a discount or premium as market prices drift below or above NAV. Institutions explain a minority of CEF ownership, causing CEF prices to more cleanly reflect retail fears and fads.

The magnitude of these pricing disparities, as measured across the capitalization-weighted Morningstar US CEF Category Average Discount Indexes, offers insights into market-clearing prices at which individual investors are willing to own different risks.

Weekly Morningstar US CEF category average discount indexes by asset class

Sources: Morningstar, Parametric, 8/31/2020. For illustrative purposes only. Not a recommendation to buy or sell any security

Based on the evolution of CEF discounts above in 2020, individual investors clearly became more risk-averse going into March and responded favorably to increasing policy intervention. However, heightened risk aversion has allowed discounts in most asset classes to remain quite elevated. Although March 18’s dislocation was intense, individual investors have yet to fully reembrace risk across major asset class categories at precrisis levels.

Even if early drawdowns have largely disappeared, volatility has become a defining feature of 2020. The rocky path of vaccine development, shifting policy, and social unrest at home and abroad each support elevated volatility ahead. Although aggregate asset-class benchmarks reflected little stress by the end of August, individual investor trading in CEFs reveals pervasive fears across risk assets. 

In place of forecasting the future, investors can consider multiple approaches to benefit from volatility: 

• Equity portfolios diversified across market capitalization and geography benefit from cross-sectional volatility through active loss harvesting and by attenuating extreme realizations. 
• Option portfolios can extract a premium when future volatility fears exceed realized levels. 
• Bond portfolios offer ballast to procyclical holdings and allow efficient cross-asset-class rebalancing. 
• Nontraditional income portfolios—including access to inefficient CEF markets—provide high cash flow utility during disrupted markets.

The common thread: research-driven and systematically implemented offerings address client objectives by extracting benefits from a volatile world.

Note: “Bloomberg” is a trademark and service mark of Bloomberg Finance LP (“Bloomberg”). “Barclays” is a trademark and service mark of Barclays Bank Plc, used under license. Bloomberg Finance LP and its affiliates (collectively, “Bloomberg”) or Bloomberg’s licensors own all proprietary rights in the Bloomberg Barclays Indexes. Neither Bloomberg nor Barclays Bank Plc or its affiliates (collectively, "Barclays") guarantee the timeliness, accuracy or completeness of any data or information related to the Bloomberg Barclays Indexes. Morningstar® (“Morningstar”) is a registered trademark of the Morningstar, Inc. This strategy is not sponsored or endorsed by Morningstar and Morningstar makes no representation regarding the content of this material. “MSCI” and MSCI Index names are service marks of MSCI Inc. (“MSCI”) or its affiliates. The strategy is not sponsored, guaranteed, or endorsed by MSCI or its affiliates. MSCI makes no warranty nor bears any liability as to the results to be obtained by any person or any entity from the use of any such MSCI Index or any data included therein.

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