Calling the COVID-19 crisis and avoiding the bloodbath

We had a strong view that the world was late in the economic cycle and we were looking for events that could herald the end of that cycle. When reports of the coronavirus first surfaced, we were already sensitive to the implications.

In order to analyse the situation, we split the statistics into two buckets: China and the rest of the world. We knew the Chinese statistics were wrong. But we could see by the actions being taken by China how severe the problem was.

In the rest of the world data, we broke it into two parts: (a) cases that originated in China, (b) cases caught outside of China. After Chinese travel bans began, cases originating from China fell, which partially masked the rapid rise in cases caught outside of China.

It was the rapid rise in cases caught outside of China and the impact of the China lockdowns that prompted our portfolio changes.

The benefit of ETFs

Nucleus Wealth runs tactical asset allocation portfolios for investors and superannuation clients. We generally target direct shares, but we still use ETFs. The three main ways we incorporate ETFs are:

• to achieve better cash returns;
• to gain easy exposure to foreign exchange for separately managed accounts; and
• in separately managed accounts, some smaller balance clients won't be able to buy all of our international stocks, and so for those clients, we replace the direct global shares with ETFs.

Our mandate is to run only cash, government bonds and large capitalisation stocks with no derivatives or short positions.

Portfolio rebalancing

We had been selling down equities progressively over January 2020 and in early February we decided the risks were high enough that we needed to protect our client investments.

We sold down equities as far as mandates would allow and looked to get hedging from the bond and foreign exchange markets. Our view was that, given Australian links to China and the high household debt burden in Australia, the Aussie dollar would be particularly vulnerable and being short it would be a good shock absorber for falling equities.

We also bought longer-term government bonds as a similar hedge on equity performance.

We used the BetaShares US Dollar ETF, the BetaShares Euro ETF, and the BetaShares UK Pound ETF – in some portfolios they made up 30 per cent of our holdings.

In a practical sense, we were effectively swapping out international equity exposure with global cash, maintaining our purchasing power for when we were ready to buy back in.

Our growth fund finished the March quarter up 0.6 per cent compared with the median superannuation fund, which was down 12 per cent.

Timing the return

We are closely watching for a re-entry into equities, but do not think the market has enough information about the impact of coronavirus. For example, 1Q 2020 US earnings only go until the end of March.

The key unresolved issue is the effect on small and medium businesses, which make up most of the economy.

We believe current stock prices are underestimating the likely impact on earnings to some sectors.