Ivy VIP Core Equity

03.31.20

Market Sector Update

  • The S&P 500 Index, the Portfolio’s benchmark, declined more than 19% in first quarter 2020 as the domestic economy shut down in response to COVID-19 related social distancing measures in the U.S. and around the world.
  • The first calendar quarter of 2020 will undoubtedly go down as a unique period in history, where we experienced a truly global pandemic that has affected every major developed economy at essentially the same time. The result has been an unprecedented shock to gross domestic product (GDP) growth with particularly negative effects on the U.S., given our dependence on consumption and services. Nearly two thirds of U.S. GDP is driven by consumption, including travel, restaurant dining, sporting events and shopping. Of the 157 million employed workers at the end of 2019, 108 million jobs were related to service industries. Nearly 16 million jobs were tied directly or indirectly to the travel industry and 13.5 million Americans were employed at restaurants. As the result of government-imposed stay at home orders, the number of Americans filing for first-time unemployment benefits increased from 211,000 in early March to more than 6.5 million by the week of March 20.
  • With unemployment rates highly unpredictable (other than the certainty of near-term worsening), U.S. GDP is equally unpredictable. Economists believe second quarter GDP could fall 30-40% with a huge error factor for unprecedented forecasting challenges. Most assume third quarter GDP will bounce back significantly (perhaps 20-30%), though this timing is certain to be impacted by the rate that social distancing measures are relaxed. At the moment, we have very little confidence anyone can predict with any degree of certainty how the next three, six or nine months will play out.
  • We also believe corporate confidence will be equally unstable in coming quarters. Having witnessed two previous recessions, we are struck by the all-encompassing nature of this shock. Businesses thought to be defensive, including Real Estate Investment Trusts (REITs), hospital and medical device companies, and even certain utilities, are seeing unprecedented effects on their businesses. Firms of all types are seeing leverage ratios rise rapidly as EBITDA (earnings before interest, taxes, depreciation and amortization) falls precipitously. For these reasons, we are concerned the U.S. is only at the beginning of a multi-month recession.

Portfolio Strategy

  • Although the Portfolio returned negative performance in the first quarter of 2020, it outperformed the index for the period. Outperformance during the quarter was due to a healthy balance between sector allocation and individual stock selection. The Portfolio benefitted from a higher-than-normal cash position, averaging over 3% during the quarter and 8% at the end of the quarter. Cash and cash equvialents accounted for slightly less than one third of the relative performance, while stock selection accounting for roughly half of the performance. Our risk positions became far more conservative early in the first quarter drawdown as it was evident the U.S. economy could see unprecedented contraction based on stay-at-home orders affecting the majority of urban populations. In addition to cash and cash equivalents, the portfolio’s underweight position in the energy sector as well as stock selection in financials (we had less exposure to spread-based regional banks and companies sensitive to consumer credit), were key contributors to Portfolio performance for the quarter.
  • Lessons learned during previous recessions (some the hard way) have helped the strategy hold up somewhat better than the overall market. 2008-2009 was instructive in that during a full- blown financial crisis; the only safe haven was cash. This time we increased the Portfolio’s cash position early in the market rout. While we have spent a lot time and effort over the years on risk management, we also know that during a precipitous shock, risk models can blow up. Lowbeta stocks can become high-beta stocks, for instance, or uncorrelated assets can quickly become correlated.Investors who owned supposedly defensive holdings – REITs, certain consumer staples, utilities and even gold – were surely disappointed during the early stages of this sell-off. That said this drawdown, like others, has differentiated companies according to balance sheet strength, free cash flow production, and earnings quality. A key focus of the Portfolio has been to avoid or reduce stocks/sectors that are disproportionately affected by the nature of the pandemic (travel, consumption, credit-focused financial institutions) in addition to managing risk factors proactively (beta, earnings quality and leverage exposure).

Outlook

  • Looking ahead, the Portfolio continues to be positioned defensively, although we seek to utilize our cash position to acquire what we believe to be discounted businesses with strong balance sheets and somewhat cyclical earnings streams. Though simplistic, a traditional discounted cash flow analysis of many moderate growth companies would suggest that year one and year two cash flows might account for 6-7% of a company’s long-run valuation if those cash flows were to go to zero. Factoring in that businesses could very well see significantly negative cash flows for a year or two during this downturn, we might expect the destruction in value to be 13-15%. Thus, when we see businesses whose balance sheets would allow them to absorb a one or even two-year shock trading at a 30-50% discount, we will seek to take advantage of those opportunities, assuming we believe the companies are equally attractive on the “other side” of this recession. Specifically, we have selectively added names such as medical device suppliers, auto parts retailers, food distributors, a health care REIT, and alternative investment managers that fit this bill. Given the underperformance of value shares relative to growth in the most recent drawdown, we may seek to add value exposure provided we have the utmost confidence in a company’s balance sheet and ability to endure a recession of unknowable magnitude. Thanks for your continued confidence in Ivy. We look forward to updating you in the future.

The opinions expressed are those of the Portfolio’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through March 31, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

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Risk factors: The value of the Portfolio’s shares will change, and you could lose money on your investment. The Portfolio typically holds a limited number of stocks (generally 40 to 50). As a result, the appreciation or depreciation of any one security held by the Portfolio may have a greater impact on the Portfolio's net asset value than it would if the Portfolio invested in a larger number of securities. Although larger companies tend to be less volatile than companies with smaller market capitalizations, returns on investments in securities of large capitalization companies could trail the returns on investments in securities of smaller companies. An investment in the Portfolio is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the Portfolio’s prospectus.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.