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Here we review recent capital market developments and share our thoughts and observations on how best to navigate these challenging times.
The last few weeks will go down in history as one of the sharpest and fastest corrections ever experienced by financial markets. The S&P 500 reached bear market territory in an all-time record of just 16 trading days. This was as much due to the largely unforeseen and hugely underestimated nature of the speed and spread of the COVID-19 virus as to a general complacency among investors going into 2020.
When capital markets go through such periods, it is often useful to assess investor behaviour and market structure. The first price drops in equities and lower quality credit seen in late February were largely indiscriminate; it didn’t matter whether a stock, or the company behind it, had a strong balance sheet, had high or low leverage or was trading at a high or low valuation multiple. In fact, in many regions it was the large companies often perceived as safer in such an environment that were hit the hardest. To us this indicates that investors who were overweight risk (mainly public equities and lower quality debt) rushed to reduce exposure and naturally used the most liquid instruments, often ETFs and large cap focused funds, to adjust their positions. Investors trading at margin (i.e. those looking for leveraged exposure) and funds targeting a stable level of volatility added to that indiscriminate selling pressure.
The next stage, seen in the last couple of weeks, was somewhat different. After the initial risk reduction came what can best be described an instinctive, simple logic reaction, where investors started buying safety offered by companies such as utilities and telecoms, and offloading the obvious ‘risk assets’ like those with exposure to airlines and restaurants. There is even a new acronym for this group: ‘BEACH’ companies – which stands for companies involved in booking, entertainment, airlines, cruises and hotels. This is to me an equivalent of the ‘toilet paper rush’ that we experienced in our everyday lives. It indicated the prevalence of rushed behaviour and the absence of proper insight and a nuanced view about the implications of the likely economic slowdown on individual companies, sectors and countries.
What we have witnessed to a much greater degree than before is the large footprint of systematic and passive fund activity in the market. High overall market and ETF trading volumes are just one side of the story. The other important part is the pattern of asset price movements. We hear that even the most seasoned investors have been somewhat puzzled by some of the action in capital markets. We have seen a few days where price action has defied conventional logic, with gold price fluctuations being a case in point. As markets fell so quickly, some of the quant and trend-following models must have been shifting from one regime to another, adding to overall volatility and confusion. We have also seen an unusually high number of extreme intra-day equity market movements. The divergence of high yield ETFs’ prices from their NAVs and general surge in ETF borrowing costs should be a cause of concern for their investors.
One striking feature of this correction is that all the speedy and more-than-substantial actions of central banks across the developed world have largely failed to arrest the panic. This might indicate that we are now truly close to the point where the belief in monetary powers’ omnipotence has reached its limits. This, in my opinion, could be behind continued high market volatility. It could also explain the breakdown in asset class correlation, with bonds and equities often moving in the same direction.
What are the implications for investors? First of all, it is clear that no one really yet understands the full extent and shape of the impact that COVID-19 will have on our society and economy. Partly this is due to the fact that we are, as a society, actually able to influence the path of future events, at least to some degree (those are so-called ‘known unknowns’). We do know that governments around the world are pursuing decisive action plans in two important areas, namely on finding a medical solution to the challenge (developing a vaccine, increasing health systems’ capacity, protecting the most vulnerable) and on softening the negative economic impact (by initiating often unprecedented monetary and lately financial support measures). Although it is logical to expect a slowdown in economic activity, government actions have the ability to materially address the effect of this slowdown on individuals, industries and companies.
We are also at the stage where we are starting to think about the longer term consequences of this pandemic on people and businesses. I believe this will be the most interesting topic for investors in the days and weeks to come. The recent events have exposed some of the fragilities of our systems and economies. Going forward, will we need to operate with a greater stress capacity in our health systems? Will the practice of self-employment and zero hour contracts remain acceptable or will we see the return of traditional full time employment? Will financial leverage in consumer-focused and service industries be viewed more negatively? Will the attractiveness of globalised supply and demand chains and just-in-time delivery systems be intact in the post COVID-19 world? Will the direct and substantial fiscal support measures (UK government paying salaries of the private sector employees or US cheque in the post approach) change the perception of what is normal in politics?
We are not experts in medical science and have to rely on the genius and hard work of everyone involved in dealing with this virus. Understanding the broader implications of any developments and their effect on companies and financial instruments, however, is something that we do know about. Now that we have passed the initial panic stage, our investment managers’ experience, perspective and disciplined analytical frameworks become invaluable in safeguarding our clients’ capital. However profound the economic and social consequences of this pandemic are, it is critical to keep a clear mind and continue focusing on the facts and quality of one’s analytical work. Any dislocations and anomalies create opportunities for long-term investors. The new nature of some of the challenges facing us means that it is often impossible to reach out to a right page in a play book. In this game human beings still have an edge over rear-mirror systematic competitors.
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