Positioning for a Post-COVID-19 World

“Stay safe.”

It’s surprising how fast a phrase can become a part of everyday life or how quickly two little words can begin providing a measure of personal connection as we close out calls, emails, and messages to friends and colleagues alike.

In the first week since the WHO declared the latest novel Coronavirus a global pandemic, we’ve seen an unprecedented impact on daily life. From wide-ranging travel restrictions, countries locking down their borders, an increase in self-isolation, and many firms implementing work-from-home policies for the foreseeable future, businesses and individuals are adapting to new ways of working.

Like many areas of the global economy, financial markets have felt the impact of COVID-19 with most major indices, commodities, and currencies around the world seeing double-digit declines during the first seven days following the WHO’s announcement:

Alongside this, much in the financial media right now remains unclear: have we reached the bottom of the fall? Will markets continue a downward trend? Will we see markets flatten? When will we start to see an uptrend? How likely is some form of economic stimulus in the coming weeks/ months?

With uncertainty can come indecision and as people work to navigate the current market environment and seek answers to these and many more questions, we considered how we might be able to provide some clarity into the impact that the next market move could have. To do this we looked to address one of the questions above and, somewhat optimistically, focused on how markets might rebound once the uptrend begins and how an investor could position themselves to take advantage of this.

Identify Market Movers and Model the Impact of How Their Changes in Might Influence the Market

We began with a relatively simple example. In the last few weeks, as the coronavirus has dominated the media, we’ve seen the price of crude oil fall to a 10-year low. The combination of Saudi Arabia seeking to boost its export of crude oil over the next two months along with a COVID-19-driven slump in demand effectively bottomed out the price of oil.

As we start to think about how recovery might take place, we can point to individual markets and commodities to see how an uptick in each could impact various portfolios and indices.

For our purposes, we looked at modeling a rise in the price of WTI crude oil continuous futures and the impact this would have on stocks in the MSCI Europe, used as a proxy for our investible asset universe. To do this in a systematic way, we applied a factor stress testing framework. This involves calculating the correlation of the price of crude with the returns of factors inside a risk model, then capturing the impact on the index as a product of the exposure of stocks in the MSCI Europe to factors inside the given risk model, beta (between oil and the risk model factors), and a designated amount by which we expect the oil series to move. Decay rates and additional methodologies are applied to the factor returns to account for an environment in which correlations are expected to change.

In this example, we began with an assumed shock to the oil series. We modeled the price of crude oil rising back to the level of its 200-day moving average price as at the end of December 2019, before the current crisis took hold; a value of around €52.

Based on current markets, we would expect such a rise to yield an almost 8% increase in the MSCI Europe:

Decomposing this number, we can see that constituents of the index trading in the UK and France would be expected to drive the increase contributing 2.70% and 1.17% of return respectively:

However, in standalone terms, Norway would be set to see the highest increase at almost 17% with (unsurprisingly) Energy stocks yielding the highest standalone returns. Norway is followed by Sweden, the UK, and Austria, all of which could see over 10% increase in return.

Had this article been written just a couple of months ago, the assumptions behind the stress test—using a target recovery level based on a relatively recent 200-day moving average price—would have seemed reasonable. However, the world and its financial markets look very different now from where they were just a few short weeks ago. As a result, the above recovery scenario is very optimistic, representing around a 110% increase in the level of crude oil from its position on March 17.

To address this, we looked at two additional scenarios for the recovery of crude. The first of these used the same target recovery level (€52) but incorporated a horizon over which the recovery would take place. By applying a three-month horizon, essentially giving the commodity time to recover, the impact on the MSCI Europe was more subdued with the index seeing just a 2.99% rise and Swedish stocks both contributing most to the index and performing best in standalone terms:

The second approach considered a recovery based on an observed historical change in the price of crude oil. Looking back to the start of 1997 (the start date of the underlying risk model used), we can observe that the highest one-day change in the price of crude oil was 18.56%, taking place during the GFC on January 16, 2009. The next highest move was the end of December 2008, which captured a one-day change of 16.28%.

By using a more conservative approach than the ones above—here targeting a recovery at around the highest one-day change observed across the crude oil price series of 18%—we see a positive impact on the MSCI Europe to the value of 1.28%. Here the UK is once again the largest contributor to the overall index with Norway holding the largest standalone change.

Explore Increasing Exposure to Target Stocks and Markets

Having considered a recovery in the price of oil, we started to think about the timing of the recovery across markets around the world. According to the UN, the number of cases of COVID-19 is on the decline in China as of March 16. Assuming a continuing trend, we could argue that China would be one of the first economies to start towards a post-COVID-19 recovery.

Accordingly, we considered how we could position ourselves to benefit from this recovery and considered two separate approaches. First, following our factor stress testing approach above, we expanded our analysis to capture the impact on the constituents of the MSCI Europe were we to see a recovery in the MSCI China Index and, independently, the Industrials sector of MSCI China. In each case, the target recovery level was the 200-day moving average from the end of December 2019 and in both scenarios, we noted that a positive recovery in China would correspond with an uptick across the MSCI Europe index:

Once again, if this article were being written just a couple of months ago, the above ideas and expectations perhaps would be worth further investigation; for example, establishing which countries, sectors, or stocks were the underlying drivers of this uptick. However, this type of factor stress testing relies on beta sensitivities that are computed between the dependent variable (MSCI China in this case) and the independent variables (factors inside the underlying risk model). With an increase in correlations taking place in the market, a question arises as to whether it is realistic to expect that a recovery in China would be driven by systematic events such that we could expect a simultaneous recovery in the MSCI Europe.

To address this, we looked at ways in which we might be able to gain increased exposure to a recovering market, again using China, to take advantage of the rally.

Here we proxied the MSCI Europe for our investible universe, seeking to mimic the assets available for a European investor. To identify which stocks might benefit from a recovery in China, we considered the geographical sources of revenue for each of the stocks in the index using FactSet’s proprietary GeoRev database. By focusing on those stocks that have a larger proportion of their revenue coming from China, we could identify a target list of securities that we might want to consider in the event of a recovery.

For example, looking at BHP Group PLC, we can see that China accounts for about 53% of the company’s revenue—an increase of around 4% on the previous year and part of an increasing three-year trend:

Considering the above, taking a position in BHP Group PLC would give an investor indirect exposure to China through direct investment in a European equity. While this approach could give increased exposure to China, such a strategy introduces additional considerations. How big a position in each security should we take? Could this approach inadvertently lead to concentration in countries, sectors, styles, etc.? To address this and scale the approach across the entire index, we turned to a portfolio optimisation process.

Here we passed the constituents of the MSCI Europe into the Axioma Portfolio Optimiser, which is fully integrated into the FactSet platform, and built a quick optimization case that focused on rebalancing the weight of stocks in the index. Our optimization objective sought to maximize exposure to stocks that generated a larger proportion of their revenue from China, as identified through the GeoRev database, while minimizing the active variance of the rebalanced index from the starting MSCI Europe. Constraints were added to ensure that all stocks in the starting index were held and that no security was held at weights higher or lower than the maximum/minimum of the starting index, to prevent idiosyncratic concentration.

Having rebalanced the index, we see an increase in weight associated with stocks held in MSCI Europe across the UK and Germany and notable decreases in France:

The top 10 securities in our newly constructed index account for 44.94% of the index, compared with just 21.60% in the standard MSCI index with BHP Group and AstraZeneca jointly holding the highest weight in our rebalanced index:

While this is a relatively arbitrary example, the approach gives some insight into which securities might provide an increased exposure to recovering markets based on their geographic sources of revenue.

Having considered geographic sources of revenue, it is also worth delving deeper into the DNA of a company’s revenue model by analyzing its supply chain. By better understanding the geographical location of a stock’s suppliers and customers, we can better identify which securities may see a revival in the case of a specific market recovery. For example, if a significant number of a European company’s consumers are based within the U.S., would that company be expected to follow a European market recovery or would its rebound fall more in line with the timing of U.S. markets? Similarly, if that same company’s suppliers are in a market that remains under duress, will the company’s supply chain be impacted despite the fact that its domestic market may have recovered?

Taking AstraZeneca PLC forward from our above analysis where we found a significant contribution to revenue coming from China, we can see that the company’s top-five ranked suppliers, partners, and customers as taken from FactSet’s Supply Chain database are located outside of China; namely in Europe (France and Spain), Japan, India, and the U.S.:

Should these markets remain under duress, we may see an impact on AstraZeneca’s abilty to generate additional revenue in recovering markets.

Conclusion

The current COVID-19 pandemic presents one of the biggest challenges in financial markets in recent history. But, as with other black swan events and market crises, this will pass and in doing so will present unique opportunities for growth. By understanding the impact of how markets might move, investors can ensure that, when the time is right, they have the information needed to act and act well.

Above we presented two approaches to help with this understanding. First, a systematic approach to simulating methods of market recovery through a stress testing framework to identify which stocks might benefit. Second, using sources of geographic revenue along with an understanding of a company’s supply chain and an optimization framework to provide indirect exposure to recovering markets where direct investment may not be possible.

Stay safe.