Navigating markets in time of crisis (Coronavirus) - Part II

Disclaimer: nothing in this article constitutes a recommendation or advice to buy or sell a security of any kind by the author. Trading in financial instruments has many inherent risks and readers should consult with specialists for any investment decisions.

This note is a follow-up to my Feb 24th "Navigating markets in time of crisis" note which was meant to provide a thought framework for investing through potential better and worse developments ahead at that time, based on my experience as a practitioner of risk markets and my experience in successfully navigating 2008.

As a quick recap, in my Feb 24th article I wrote that if a negative scenario developed (and I put a 35% probability on it as we prepared ourselves for it):

"Central Banks would intervene (PBoC has already) and those governments which can (i.e. some developed economies) will likely release economy-boosting packages

Rate cuts will result in lower rates in US & Canada in particular as they are one of the few developed jurisdictions with overnight rates above zero.

As a result, USD and CAD (vs. rest of currencies in zero rate countries such as SEK, EUR, NOK, etc.) are likely to fall.

Refuge values will continue to be bought: precious metals will continue their rally while longer term US rates (and CAD) would drop lower, increasing the probability of Japanification.

Commodities will continue to suffer as global demand will falter.

 Most importantly, this might be the catalyst for a lot of corporate debt to start coming under pressure. In fact, while sovereign rates will go down, corporation could face difficulty refinancing as their net results will drop. Given the tremendous run higher (in quantity and price) of corporate debt and the wide success of many private debt instruments (alternative fixed income bought to replace low yielding bonds), this corner of the market could be particularly vulnerable albeit in medium-term – once slowdown trickles through results - rather than in short-term."

All the above projections have so far materialized with the (partial) exception being the increase in price of precious metals. While they initially rallied, the subsequently came down following the same trend as equities. We will cover this later in this note.

How to think about what is ahead of us?

Once again, I can not emphasize enough 2 things in the process of looking ahead and appraising the future:

1) The most important thing for any policy maker, investor or risk manager is to do away with absolute certainties in their thought process.

"The Coronavirus is very much under control in the USA. … Stock Market starting to look very good to me!” This is President Trump on Feb 24th! History is filled with such statements that were reversed shortly (Bernanke in 2008, etc.)

2) As practitioner of derivatives and risk I live in world of probabilities and the probability of extreme outcomes at this point are far from negligible. It is highly recommendable that investors and policy makers thing in probabilistic terms. This is something that as human's we are not wired for and requires conscious effort and discipline. (Had they done so 2 months ago we might not have been at this point)

Now let us have a practical approach to what is ahead.

What we know and what we observe presently

It is always a good idea to start by the "known" and then look at the unknowns that affect the outcomes.

With regards the Coronavirus and its developments, here are a few things we know.

• We know that the virus was not contained and now it has made its way to many countries and is likely to continue that way and number of affected people goes up continuously.
• We know that some countries had success in keeping a lid on its propagation (Hong Kong, Singapore, Vietnam) and a few countries are facing major challenges and the spread is being disastrous (Italy and Iran in particular and Spain seems sadly on its way)
• The questions should be why such disparity in the rate of spreading. The short answer is social distancing is the only known effective tool we have.
• We also know that if contagion increases healthcare systems (even in advance economies) will not be able to handle the related flow and the infrastructure can not respond to the needs. Again, Italy and Iran confirm this fact and it is one important reason that other European countries have been so proactive in enacting social distancing.
• A vaccine is on its way and it is very likely to be here at the latest by next winter (10 months away) but probably not earlier than mid-fall (7-8 months)

At this stage much uncertainty remains as to how in the weeks to come the numbers will evolve. In particular, whether the numbers in US ramp up or the situation will be somewhat controlled will be one of the main key elements to where we head from here.

With regards policy its developments, here are a few things we know.

• Rate cuts took place (Canada, US) and policy makers are well aware of the fact that rate cuts alone will not be sufficient, there has been emergency funds and stimulus (US, EU, Japan, etc.) thrown at the problem and some jurisdiction have well understood that macro prudential measures will also be needed (Italy has suspended mortgage payments).
• There has been very little global coordination. Whether it concerns economic policy (G7 Finance Ministers communique was void of content, why Central Banks cut rates a few days apart with no coordination unlike 2008 crisis). Travel bans and social distancing measures also have been largely uncoordinated, even in EU where there are strong institutions that have worked for decades together on legislations and projects of all kind.
• This lack of coordination is in part what affected investors pshycology. In times of crisis you look at the captain and crew of the boat to get a sense of security. How secure we felt early last week? Friday's speech by President Trump and the show of unity wa sin great part meant to project control and sense of security, albeit with a US focused perspective.

At this stage much uncertainty remains on the willingness and ability of governments and policy makers to coordinate and devise appropriate fiscal, macro prudential measures assuming they have the practical means to do so.

A few observations, when looking at market commentary, trading data and price action.

• First, the "recency bias" is very present and rampant, and I would add alarmingly so. Many investors have been conditioned by over a decade of one-way price action (up, up and up) in risk assets, have witnessed only some of the strongest and fast reversal in history (December 2018 being the most notable example). The market commentaries are filled with calls to buy the dip and how this as an opportunity for the brave. Some of those who had (wisely) cash sitting on sidelines see this as the time to "load up" and an opportunity to riches. But is it really the case?

Observing the biggest one day drop since 1987 (Thursday 12th) or rally since 1933 (Friday 13th). Is it a good time to buy? Will we ever see the highs we had again or supersede them? It might very well be the case but it would be wise to look at the historical context.

I will not cover the Great Depression here, but is important to know that it took over 2 decades for the equity indices to make it back to flat!

If we consider that today's economic uncertainty is due to a supply (followed by a demand) shock, then historically the 1970s are probably most akin in many ways. I am not implying a direct comparison, simply asking those convinced by buying the dip: shouldn't we look a bit further back?

• Second, it appears that suddenly many market participants have turned economist and fundamental analyst. Financial commentary and outlets are filled with suggestions of what is has good value now and how the economy will look in a few weeks or months. I will confess, I can not put a number on where we are in a few as far as the markets or assets are concerned or how the economy will look or what the human toll of Coronavirus will be. If anyone knows that, then I am a taker of insights. What I know is there are many unknows and most people will do away with them and replace with their own conviction and views which is not a wise approach.

"Overconfidence bias" is the other one that plagues markets during crisis periods. One feels strongly about something being a good buy and value right now, but here is a scenario: if you bought the S&P500 in November 2008 you would have suffered another near 40% loss by March 2009. Would you have held on to that position (assuming you had enough margin to do so and the Prime Broker did not ask you to pare back)? I was around then, and I can tell you that many did changed their minds or were forced to do so along the way ... (thankfully I am not a fundamental stock picker so I did not have that dilemma)

And remember for making up 40% loss one needs to generate 67% returns, losses are not symmetrical.

So where to now and how to think about positioning?

At this juncture, and in light of all the above what will be very key (this is not a restrictive list) to where we are heading is:

A) How the Coronavirus situation as far as the speed and scope of contagion are concerned in US evolves.

B) Will the policy makers act on avoiding that an economic problem turns into a financial or structural problem? And if so how astute and effective will they be?

The good outcome:

Measures taken (and those to come) tame the progress and "flatten the curve" of the virus' spread in US. Society as a whole and investors will be relieved. In that case, the problem will remain an economic one with much unknow effects. That is because if US has to continue to self-isolate (if the rest of world struggles or more countries get affected) then many of challenges to business and local economy will continue (export, import, tourism, etc.)

But in this scenario a financial contagion will likely be avoided, the pricing of risk will somewhat relax (as tail-events and Armageddon scenarios will be off the table), while the market might see some relief, rates which have gone near zero by then are likely to be sticky as the economy stabilizes. The real picture of "life after Coronavirus", will emerge slowly and only then an in-depth "inventory" of the situation can be established, akin to those done during war episodes.

The difficult outcome:

In the weeks ahead the US faces a challenging increase in number of cases and fatalities and a healthcare system under strain (like Italy, Spain, Iran). The public psyche will be highly affected and confidence shaken which is likely to put further pressure on risk assets. Baring proper macro prudential action by policy makers, the problem could get aggravated by permeating into the structures of the financial markets. For instance, we could see - similar to 2008 - forced selling and forced deleveraging by hedge fund an client accounts as dealers increase margin requirements. This will exhacerbate the market psychology and those who bought today's dip will face grueling decisions (if they still have the cash needed to hold on to positions).

In this scenario we would already be at the zero-interest rate boundary with few tools in Central Bankers' box (an asymmetry I have highlighted since 2013). One could expect the types of government action we have not seen in recent past (a look at back at 1970s and WWII for more info). It is fathomable that a Japanification on rates (already a reality by then) could be complemented by something similar to a Japanification in equities (the Nikkei 225 never got back to its highs of 1989s). Similarly it is also possible to see actions which would in essence be meant to "bail out" the private sector and small and medium size businesses to avoid a credit cycle (defaults) that would shake the whole system. We will not get into more details as the conversation can be virtually endless given the possibilities.

In fact, it is worthwhile pointing out that unlike what is protrayed in the financial media and what is taught in universities: equities are not necessarily bound to go up over the long term. In some way US equities have almost been the only ones to do so, rather an exception. Examples to the contrary abound, France's CAC40 never got back to its highs of 2000s, the UK's FTSE100 is at similar levels now that it first reached in 1997, and the Shanghai index never made it back to its highs of 2005, etc.

Positioning

The goal is to define a positioning that would potentially benefit in either outcome or at least not suffer major losses in either of the difficult or good outcome. Our above analysis shows how difficult it is to answer this at this juncture. Here are a few thoughts.

• Given that rates are likely to stay here (good outcome) at best or go lower (difficult outcome), those who are naturally long government bonds have an incentive to hold on to them, baring a breakdown of bond markets (the Fed has so far signaled clearly they will try to keep that orderly and expect more at this week's FOMC meeting).
• Despite the recent sell-off (from recent new highs) precious metals are likely to find their traditional safe heaven appeal. In 2008 they also sold off along all other assets as some deleveraging was happening at the start of the crisis, only to run up once rates were cut and the crisis accelerated.
• With the exception of oil, many commodities have not retreated much in value. Should the outlook get dimmer, they could drop in price while their upside is probably limited in case the situation stabilizes.
• There will be a time under both scenarios where risk pricing will ease, if anything because volatility is mean reverting. Under both scenarios, we will have more visibility into what is ahead and the damages done in a few months time. Addionally, we would expect that as humans have always done, we will be resilient and adapt to the situation (better or worse) and that in itself will result in the relaxation of risk pricing and it will be a time to benefit from that drop on risk prices. (This is not a place to enter into details of such structures, but happy to have conversations about it on the sidelines).
• If an investor is compelled to take a strong directional view, it is wise to do so in a way that his/her losses are capped by design. Despite high option prices, there are many ways to achieve this conditional outcomes (again I can not get into details here but that is our specialty and we are happy to help).

I will use my Feb 24th conclusion here: "by saying that as a system or group (i.e. the world) we have not witnessed a pandemic in long time (1960s). What lies ahead is anyone’s. I am neither a virologist or astronomer and really hope that things turn for the better. But being risk-conscious (not risk-averse) is wise and something we might have lost the habit of given the last decade of “fun”. No matter what lies ahead it is important that everyone gives the matter (risk-awareness) some thought."

And finally, for the record, barring an imminent medical breakthrough I put the probability of things unravelling to the left (difficult outcomes) 30-40% and the right tail (good outcome) 15-25% (and the rest somewhere in between).

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