The unexpected, the unwinding and the unknown

March 19, 2020

Euro | money | coins | liduidity

1. A massive and unexpected search for liquidity and cash

What we are seeing in markets today seems unprecedented everyday: volatility (VIX) around 80, treasuries and gold losing ground when equities loose more than 5%, oil price losing more than 25% intraday. Beyond all the explanations on the market rational anticipation of a recession and more sovereign risk due to higher spending, these last few days look like a massive and desperate hunt for cash, in which leveraged investors need to offload assets at any costs. Multi-asset allocators start to rebuild cash buffers even if this means selling equities and gold at the same time. The risk that fund managers need to manage in this confinement context is to be unable to meet withdrawals due to inadequate liquidity. The risk that institutional investors try to manager is that treasuries no longer offsetting the volatility of equities and credit. When liquidity constraints dominate, price no longer matters. This is where we are now. This is what explains tensions on repo markets and buying pressure on the dollar, and why the Fed has to implement swap lines to provide dollars. The unexpected is the significant correction on government bonds yesterday.


2. GUS : the Global Unwinding Shock

This hunt for rebuilding cash positions is not only the result of traditional long only asset allocators: it is also the result of a global unwinding of leverage, from individual investors to hedge funds, that face margin calls or greater deposit constraints on their derivative positions and are forced to offload assets, probably at one of the worst moments of the last few years. This volatility shock pushes every investor to test its own limits in terms of capacity to absorb volatility and to keep a long term investment approach. The unwinding moment is the Minsky moment of this market cycle: when leverage positions are unbearable in terms of volatility and face the risk of margin calls, assets that were supposed to be held in the long run are suddenly sold.


3. The inequality and asymmetry of liquidity

Like in previous volatility events that are outside the normal framework of risks and correlations, asset allocators need to manage drawdowns by rebuilding cash when traditional correlations no longer works. The issue is that not all asset classes are liquid. This explains why some investors can still agree to sell value stocks yielding close to 10% of dividends, because equities are still more liquid than credit and selling the most volatile equities will reduce volatility faster. When we reach this point where investors sell for other reasons than being bearish on the price tag, we should anticipate either that things will become very bad, or that we are at maximum of the capitulation phase which means that the end of the correction is approaching.


4. Instant Replay: a sudden reset of fundamental assumptions on the cycle outlook

Only a few weeks ago, most economists were resisting the idea that global growth could slow down more than a quarter and that global growth in full year 2020 could go significantly below 3%. The future will tell if we are being too pessimistic, but the bottom up message we receive from companies progressively suspending factories is that Q2 numbers will look bad and we should get a confirmation of that with next week PMIs release. From a mathematical standpoint, it only takes a month or two of freezing and confinement to end up in recession on a full year basis but what matter now is the length of this macro correction and the quarterly recovery path. However, we should be mindful of the fact that this shock on output should remain temporary and that the biggest risk of this shock leading to massive corporates bankruptcies and insolvencies should be avoided by a reactive policy mix.


5. Testing the resilience of macro hedges

We are facing abnormal correlations, in this market context: gold goes down when equities go down too, and treasuries have no longer played their role of shock absorber. Whilst gold seems to reflect more technical phenomena (margin calls), government bonds repricing seems to reflect like in 2010 the risk that voluntarist fiscal packages lead some countries to leverage too rapidly, causing some interrogations on the sustainability of ambitious fiscal policies. This explains why the ECB had to intervene and announce a significant emergency asset purchase program, which should stop this trend.


6. A recalibration of risks and fundamentals in an unknown territory

This situation pushes investors to redefine the outlook on corporate earnings and default risk. If analysts think that earnings could go down by 10% or 20%, what should be the impact on equities valuation multiples? Putting some numbers in a table reveals that European markets drop reflect much more than a 10 to 20% earnings drop, which is less true in the United States. On that front, our base case scenario is now that EPS growth could drop by 10% in 2020. Therefore, the magnitude of the present correction can partly be explained by a liquidity/volatility loop, by irrational fear or by a more severe scenario that we currently anticipate. Beyond fundamentals, the unusual nature of this crisis and the uncertainties of the pandemic length pushes investors to establish the parallel with 2008 and replicate the same behaviours.


7. Our revised scenario and probabilities

We will indicate this week in our Monthly House View that we have revisited our investment scenario the following way: we have increased the probability of the risk case, which becomes the central case, with global growth around or below 2% and with a more pronounced profit recession that we anticipated. Most mature markets should be in strong recession in Q2 2020. This scenario reflect the ongoing nature of the pandemic with a large number of countries involved and a necessity to implement more strict confinement measures. Under this scenario, companies may face a longer demand shock than anticipated. However, we do not adopt the view of a long and deep recession; we think that this violent shock could last until Q3 and that economy could rebound in Q4 2020 and in 2021, in a context where fiscal and monetary policies are very supportive even if their effect could take time to fuel in. What matters now is not the FY GDP growth number but the quarterly trajectory. In the end, it will depend upon the capacity of governments to control this pandemic in a reasonable timeframe and avoid a reacceleration of contamination.


8. What should we rely on in this context?

We continue to advise to hold on to quality assets in portfolios and to revisit the calibration of illiquid assets, whilst  trying to exploit this correction to get exposed to secular trends such as digital, healthcare and environment. We believed yesterday that we were approaching a level of stress at which the ECB has intervened on peripheral debts. This is where we are today: the massive decision of the ECB overnight should tighten sovereign spreads, and this can contribute to stabilise markets. This context will offer significant investment opportunities but we need to keep in mind that volatility will remain elevated and rebound can hardly engage if the pandemic does not peak. This is the unknown part of the equation. But the certainty is that the pandemic will peak at some point and risk asset returns over the next two years should be significant.

March 19, 2020

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