by Christoph Schon, CFA, CIPM
As the immediate effects of the rate cuts from the Federal Reserve and the Bank of England start to wear off and authorities in the US and the UK prepare for a potential Italian-style lockdown, investors are beginning to brace themselves for yet more market turbulence. No one knows, of course, how much more share prices are likely to fall. However, stress testing is a good way of estimating the impact of another stock-market downturn on other asset classes.
In this blog post, we analyze the effect of an additional drop of 10% in the S&P 500 index on Qontigo’s global multi-asset class model portfolio. We use the transitive stress-testing capabilities in Axioma Risk™ to estimate the impact on various asset types, calibrating pricing-factor betas and covariances based historical periods of similar or worse selloffs. The table below shows the exact start and end dates with the actual share-price, bond-yield and exchange-rate changes.
Stress Test Calibration Periods and Actual Market Movements
The table at the bottom contains the simulated returns for a choice of asset classes under each scenario. The average return for the US equity portion of the portfolio is, of course, close to 10%, which is the shock we applied in the stress test. The breakdown by sector displays the familiar split between cyclical sectors, with financials, IT, materials and industrials on one side, and more defensive sectors—utilities, consumer staples and healthcare—on the other.
It is notable that in the most recent scenario, the energy sector displays the biggest loss across all equity investments and time periods. Its performance is naturally linked to the oil price, which also, not too surprisingly, exhibits the biggest drop overall when using current correlations. Gold, on the other hand, benefits from its safe-haven status in the majority of the scenarios.
High-quality sovereign bonds from Germany, the United Kingdom and the United States also see their prices increase, as risk-free interest rates decline. The bond returns shown are normalized to an average duration of nine years to make them comparable. Italian debt can be expected to be hit the worst in the current environment, followed by Spain and, to a certain extent, France, as the number of reported coronavirus victims in those countries rises. The spread increase between Italian BTPs and German Bunds is most pronounced in the Q4 2018 scenario, which encompassed the dispute with the European Commission over the projected fiscal deficit.
Italian and Spanish stocks are also among the worst-hit local markets in Europe, although losses on that side of the Atlantic tend to be less pronounced across the board when compared with the US. The simulated downturns are even smaller when looking at the APAC region. China, in particular, stands out with a predicted loss of ‘only’ 2.6%, which probably reflects the recent decline in the number of new reported coronavirus cases.
The Japanese yen is, as usual, one of the biggest beneficiaries of unrest in other parts of the world, with an expected appreciation of between 1% and 3% against the US dollar. The Swiss franc is also likely to capitalize on its safe-haven status, though to a lesser extent. The expected directions of euro and pound are less clear, although it is conceivable that these two could also benefit from a broader dollar weakness in the current environment.
Simulated Asset-Class Returns
