Bedrock’s Newsletter for Friday 1st of May, 2020

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 Friday, 1st of May 2020

 

“Injecting some confusion stabilizes the system.”

 

– Nasim Taleb

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Happy May Day to all our readers! The European spring festival began in ancient Rome, where it was held in honour of Flora, the goddess of flowers. However, after the international labour movement chose May 1st for celebrations of working-class life in the 19th Century, the holiday went global and became associated with sometimes violent demonstrations by communist and radical groups. In contemporary Vietnam, China, North Korea, Cuba, and other socialist countries, May Day is usually marked by mass gatherings and lively crimson parades of loyal trade unions and the latest military hardware. This year, however, events have been cancelled around the world, and governments have urged solidarity through social distancing instead. Indeed, Kim Jun Un – perhaps leading by example – has gone to ground for several weeks already. Apparently, even the revolution must wait for lockdown to end first.

 

While on the subject of utopian fantasies that rely on unprecedented government intervention for their success and can inspire crowds of naïve individuals to sow the seeds of future economic disaster, the S&P 500 is now trading just shy of 3000. April was the best month since 1974 for the benchmark large-cap US index, despite the economy contracting at the fastest pace since WWII, and 30m Americans having been laid off in the past six weeks. The rally comes after a period of staggering volatility in March, when the S&P 500 moved 5% on average each day. As we approach summer under quasi house arrest, what do the past two months tell us about the current market structure, dominated as it is by passive flows, factor investing, and quantitative and relative value strategies?

 

Firstly, it is clear that equity volatility, which was heavily sold in recent years, can re-appear in periods of acute market stress with a ferocity that suggests it is keen to make up for lost time. Evidence for this new structural reality first emerged in February 2018, when the VIX (a common measure of S&P 500 index volatility) unexpectedly doubled in a single day and a number of ETFs that were systematically selling volatility disappeared overnight. Nevertheless, investors failed to heed the warning, the VIX short positions were re-established, and volatility evaporated once more.

 

Secondly, cross-asset correlations, which so-called ‘market neutral’, relative value, and other long-short strategies require to be fairly stable over time in order to calculate VaR and other measures of portfolio risk, will tend towards 1 when ETFs and mutual funds become forced sellers into illiquid markets. This causes such strategies major stress. Their highly levered portfolios are often built by backward-looking quantitative models that use the most recent measures of (often compressed) volatility as well as 12-month rolling cross-asset correlations as inputs. When correlations and volatility spike, these strategies all-too-often find that a black swan ‘outlier’ event is underway, and they are geared into a downturn that is progressing at speed. The quant models begin (slowly at first) to react to changes in the inputs, but soon they join the ETFs and mutual funds in a fire sale. A vicious cycle of deleveraging soon develops, the only way out of which is for central banks to flood the market with liquidity and convince real money to stop selling. Given their experience since the 2008 Global Financial Crisis, this is what investors have come to expect. And any delay only hastens the sell-off. Longer term, the existence of this monetary backstop creates a dangerous problem of moral hazard and perpetuates the fragility that makes it necessary. But, for now, there is no alternative. This roof needs to be fixed while the sun is shining.

 

The sell-off in March was an extreme example of what the new market structure can conjure up when real money investors panic and also cut risk very significantly and quickly. However, the incredible rally in April was no less its product. Most companies have offered little to celebrate this earnings season, while the latest economic data (for Q1) shows the harm that only a few weeks of lockdown can cause major economies at the aggregate level. For example, the US announced this week that GDP shrank by a whopping -4.8% in Q1. What will that same figure be for Q2? Presumably, it will be a double-digit decline if the abysmal PMIs for April are anything to go by. To be sure, some companies have beaten expectations for earnings and revenues since the end of March. Alphabet, for example, confirmed that sales increased +14% YoY in Q1. And this dispersion of fortunes reinforces our commitment to active management. However, the bulk of businesses (where they still exist) are currently in survival mode, worried about refinancing their capital structures while so much uncertainty prevails. Is this the moment for the S&P to be closing in on a 3000 handle? What does that say about the sustainability of the rally?

 

Well, we would answer that although the move has indeed been remarkable – in scale and speed – the massive monetary and fiscal support offered by governments and central banks cannot be discounted. The cost of the lockdowns and continued social distancing may amount to ~15% of GDP this year, but stimulus packages have been of similar size. In some countries, such as the US, the fiscal response has actually been larger than the predicted economic harm from the virus in 2020. Rational investors, therefore, should be able to look through the near-term pain and consider the outlook at least 6 months from now when life is, in all likelihood, returning to normal (or thereabouts). Of course, many uncertainties remain, and there will be hardship whatever central banks and governments pull out of their magic hats this summer: the massive layoffs at Boeing and BA are prime examples of this. But we suggest that you do not “fight the Fed” on this one – just buy hedges to protect your gains!