Friday, 12th of June 2020
“May the wind be always at your back.”
– Irish Blessing
Equity markets went into reverse this week as investors finally woke up to the fact that they were flying too close to the sun. Since the US market peaked on Monday, the S&P 500 has seen three consecutive days of losses for the first time since the index bottomed in late March; and the Thursday drawdown – which was a whopping -5.9% (and -6.9% for the Dow Jones Index) and the largest single day correction since 16 March – has triggered more than a little déjà vu. European markets were also on the ropes this week, as indices paired back some of the large gains made since mid-May. By Thursday evening, the pan-European Stoxx 600 Index was down -5.9% for the week (after a -4.1% drawdown on the day itself), and the results are even worse for individual country indices. The French CAC 40 (-7.4%), German DAX (-6.8%), Italian FTSE MIB (-6.8%) and British FTSE 100 (-6.3%) have all suffered disproportionately from the shift in investor mood given their high exposure to value and cyclical sectors that had seen a meteoric rise in recent weeks. Elsewhere, the panic even managed to break the momentum that was building in emerging markets, where a nine-day winning streak for the MSCI EM Index came to an abrupt halt with a -1.9% loss on Thursday (in USD). Meanwhile, in fixed income, US HY spreads have widened out once more, with a 46bps move on Thursday alone. The move in US IG spreads has been less marked – just 10bps – but this is by no means insignificant for the asset class. After such a big one-day correction, we expect a small recovery across markets and asset classes today. But a further downwards move may yet follow.
The remarkable rally that has taken place since March has been fuelled by a hubristic sense of optimism among investors that governments and central banks can paper over the cracks created (and exposed) by the pandemic. To be sure, monetary and fiscal policy matter – a lot – and the stimulus measures implemented to combat the coronavirus have been very large indeed. But markets must be anchored in reality for rallies to last. And alarm bells have been ringing for weeks as the flood of liquidity began to lift even those sectors (e.g., airlines, casinos, and cruise liners) that face long-term challenges from the coronavirus. The momentum built despite lasting uncertainty over the pace at which lockdowns could be lifted safely, unprecedented weakness in economic data, and a major crisis in Hong Kong, which has driven a wedge between China and the US at a time of historic tensions. Now it looks like dawn is breaking, the music has petered out, and investors – drunk on liquidity – have found themselves dancing with assets that look a little less attractive in the harsh light of day. Farcically, the trigger for the sell-off appears to have been something as innocuous as the Fed reminding the world on Wednesday that all is not well with the economy. Well, obviously. That said, also partially responsible were reports that the coronavirus is once more spreading in some US states that have begun to re-open – and market jitters are hardly surprising if a second peak is looming. This seems unlikely, but it cannot be ruled out simply because no one wants one, and the Donald will be doing everything in his power to boost growth ahead of the November election. A fair-weather portfolio is not appropriate in conditions of such radical uncertainty.
This is why, since the coronavirus first burst on to the scene and upended the global economy in early January, our portfolios have been cautiously constructed, with enough cash, gold and equity protection to weather short-term volatility, but also sufficient equity exposure to catch rallies when they appear. Our goal is to compound returns over a long-term horizon, and, since ‘fighting the Fed’ is futile and the equity risk premium is strongly positive, exiting the market in any considerable size is not an option. Instead, we have sought to manage returns through the use of strategic hedges, taking advantage of a change in market structure that has caused volatility (and the cost of buying protection) to cycle through very sharp peaks and troughs. Whether we have entered another period of outsized volatility, or whether Thursday was an outlier – a blip in an otherwise rosy environment – is unknown at this point. However, we are happy to have our protection in place.
Despite the prevailing sense of uncertainty, one area that will certainly receive a positive tailwind in the months ahead is high-quality US ABS. On Wednesday next week, the Fed will begin to offer cheap term loans to investors in new AAA ABS issues under the so-called TALF II programme. This will continue until at least 30 September. The aim is to tighten AAA ABS spreads – which have blown out due to the coronavirus – and improve secondary market liquidity for ABS at a time of acute stress. The programme will ensure that banks can continue to offer loans to businesses and households, safe in the knowledge that there will be significant demand for any ABS issued after the securitisation process is complete. In 2008-09, the TALF I programme was instrumental in the proper functioning of structured credit markets after liquidity evaporated and spreads widened. There is every reason to believe that TALF II will have a similar effect, driving spreads tighter. Indeed, it already has. We suggest that you keep an eye on the wave in high quality ABS, even if the Fed loans themselves are out of reach.