Equities have passed the Covid-19 test, reserve manager says

Equities seem to have passed the complex test posed by Covid-19, according to a reserve manager whose central bank adopted these assets over the last decade. The assessment may boost portfolio diversification in the years ahead.

“Even during this period of heightened volatility the equity performance of our portfolio wasn’t as bad as one could have imagined,” said an official at a Baltic central bank on October 27 at Central Banking’s National Asset-Liability Management Global conference. “So, currently we have sort of appreciated our allocation in this asset class and we are maybe moving forward to increase it some more in order to further diversify our portfolio.”

Following the global financial crisis of 2007–09, the low-yield environment in triple-A sovereign bond markets encouraged reserve managers to look for alternative investments to preserve capital and, if possible, boost portfolios. Riskier assets such as equities and corporate bonds have been increasingly adopted by central banks.

Critics have warned these exposures may prove too dangerous in periods of heightened volatility. However, after the turmoil recorded in March and April 2020, their performance has been very solid. In fact, in spite of the sharp losses record through the spring, the S&P 500 index has risen by 1.6% in 2020 in earlier trading today October 28.

Sceptics point out this is the result of unprecedented stimulus from the Federal Reserve, through record-low interest rates and asset purchases programmes. However, the Fed’s forward guidance indicates these tools will not be withdrawn soon, and would be likely redeployed in the event of future crises.

The Baltic central bank added equities to its official portfolio in 2018 with a rule embedded: “If at any given point in time equities fall by 10% or more from the previous time of assessment, we needed to front-load scheduled investments at those distressed prices,” said the official.

“This year we managed to front-load two investments with this rule,” said the Baltic official. “It was a quite an experience to have such a drawdown so soon in our equity investment programme. Of course, it was a little bit scary. Equities on a standalone basis are very volatile, as it happened in March and April. On the other hand, if you look at the portfolio level, most of our investments are still in fixed income.”

The official also praised the overall performance of mortgage-backed securities (MBS) through 2020. The central bank invests roughly 20% of its reserves in MBS, a part of the portfolio entirely managed by commercial entities. It adopted the asset a decade ago, a strategy that has yielded positive results. “Historically, it has been less volatile and provided higher returns than US Treasuries, while also enjoying the guarantee of the US government,” said the official.

The good performance held up during the Covid-19 crisis. “In March, this asset class did experience larger volatility given the uncertainty regarding the US housing market and also the salaries and financial well-being of US consumers,” said the Baltic official.  Nonetheless, MBS “rebounded very quickly, and actually it has done pretty well this year as the benchmark has returned 2.5 basis points so far this year”.

For this central bank, asset-backed securities (ABS) offer a very similar profile. ABS securities represent a substantial part of the central bank’s internally managed portfolio. “Of course, during the risk-off period in March they registered some sell-off, but afterwards they have behaved very well. We are still in favour of holding these securities,” added the official.

Business continuity challenges

An initial concern for reserve managers during the opening stages of Covid-19 was related to operational difficulties derived from social distancing measures. Suddenly, staff members needed to carry out their duties from home, an especially challenging environment for reserve managers.

“We first needed to equip the staff with the technical devices to allow the remote access to our infrastructure. Then the issue was to legally solve the problem of people working from home,” said a reserve management official from a central European country.

The reserve management team of this central bank split its operations into two teams, one operating from home and the other from the office. Every two or three weeks the teams would swap locations.

In this environment, security becomes paramount. “Reserve management is a secured area, not everyone in the central bank has access to this area. So we had to deal with the question whether to work, to transact, and to settle transactions from home was safe,” said this reserve manager. “Of course we have to set up new lines and new channels of communication. And they have to solve, what would be the back-up site.”

An official from an international institution pointed out prior to the pandemic its staff already had laptops with VPN connections to the institution’s network. “The major problem to overcome was off-network bandwidth, which took a while to actually fix,” he said. “But now it’s been smooth. For what is the last two or three months.”

In terms of rules, “some training procedures needed to be updated. And a couple of extra procedures were added in,” he said.

The Baltic official explained the institution rapidly transitioned to teleworking in March, following restrictions implemented by the government to contain the pandemic. As a result, only around 30 people worked physically at the bank out of roughly 500 staff members.

As cases dropped close to zero in the country, staff returned to the office. However, the second wave reached the country in mid-October, and teleworking has been re-implemented. “It’s not obligatory, but we are telling people that if they are able to work from home they should do so,” he said.

“Technologically, we were ready to switch due to the laptops available and our systems. However, security was a top concern, especially on the reserve management side,” he said. “Suddenly, we needed to let people trade from home while dealing in tens of millions of euros, while not being able to personally oversee them. That was a big technical and security type of change that we experienced.”