Risk Waits for No One

Where Are We?

Quite simply, we are in truly unprecedented—albeit, some would argue, not unforeseen—times in the modern age. A VIX close of 82.69 on Monday March 16 (a record), +24.86 from the prior close (another record!), and two of the top five worst one-day performances of all time for the Dow Jones. The March 16 performance of -12.93% was bested (worsted?) only by Black Monday 1987. We hear you, Boomtown Rats.

We’re in truly esteemed crash company at this point, with the Great Depression being the only other contributor to the top five, along with Black Monday (October 28, 1929), and followed quickly by Black Tuesday, October 29, 1929 (shall we just take the ‘black’ prefix as read? We really need to get some more imaginative prefixes at this point). What is it with Mondays? (Yes, I get it, a Monday is essentially three news days in one, so we can expect a little extra volatility).

Before March 2020, 92 of the top 100 all-time VIX closes took place during the Global Financial Crisis just over a decade ago. Now, short of that period, the top five closes of all time were in March 2020. Outside of the Global Financial Crisis, we’re currently in the most volatile period in living memory.

Who Are the Victims?

We’ve seen a monstrous repricing of risk. Some would say we’re just witnessing the air being let out of the hugely inflated valuations of recent times, but it’s been violent nonetheless. Suddenly, Italy doesn’t seem just 128 bps riskier than our stalwart Germany, as it did in February, and spreads have widened out almost vertically to 269 bps. The European Central Bank reeled that back slightly with some positive action but we’re now seeing more cautious risk pricing than we have in recent times.

CDS spreads have exploded, with the below values showing a percent change over the levels seen just one month ago. Any way you look at it, everything went up. Bigly.

While we’re on the subject of default risk, we can’t not discuss spreads in the corporate market. High Yield went up vertically, and even Investment Grade is seeing major flights.

A lot of this volatility comes from the energy sector (we haven’t even gotten to Saudi Arabia and that decision yet—what a time to be alive!), but it’s certainly been a case of shoot the general and the troops scatter. Every sector is in the red.

With the credit markets in full panic mode, we can expect big problems with refinancing and those due to refinance upcoming debt maturities. Here are a few examples.

Our trusty rates market has even gone awry on us. We’re looking at released volatility of quadruple the decade average in the 10-year note and enough whipsaws to last a lifetime. Alongside other usual suspects, MBS book convexity hedging has been blamed at the long end and right now, volatility is here to stay.

King Dollar has returned. Since the immediate carry-trade unwind gave rise to weakness in the dollar (specifically versus the funding currencies JPY, EUR), the dollar is on the up; it’s helped in no small part by a global USD shortage, only set to worsen with global trade grinding to a halt. Fed central bank liquidity swap lines have assuaged this immediate grasp for dollar, but will the Fed have too few fingers to plug all holes? What with the $700 billion quantitative easing bazooka, increases in repo activity, and now direct business lending, they will be spinning plates.

We’ve seen both gold and oil struggle, for different reasons, and the DXY can’t be helping. Oil has disappeared in the wake of the Saudi-Russia hot and cold war, and gold dropped over 10% peak to trough in the wake of the “sell everything” mid-March mayhem. It now appears to be at least behaving somewhat as expected and has rallied off the lows.

Physical vs. paper gold disparities are beginning to appear as physical gold supplies have seemingly dried up. Whether these are legitimate structural issues and the two have become detached or whether it’s just a reflection of mass disruption in delivery due to the global shutdown, no one knows.

Oil, meanwhile, still can’t catch a bid. Hey, at least that’s one strong-oil-shaped global growth hurdle removed! In reality, we’re just seeing everything sell-off as books deleverage and even risk-off positions are liquidated to reduce exposure and generate margin.

Let’s complete the circle and come back to what matters. Economics. There is nothing else to say except we have a big storm brewing. Ugly scenes are emerging in jobless claims as we saw a spike of 30% week-over-week for March 13, with 70,000 new claims. For reference, it was only on this date that Donald Trump declared a national state of emergency, and no states had yet enacted lockdown orders.  

In the first print since lockdown began, March 20, we saw a spike of three million versus the previous week. Quite the spectacular print, albeit not unsurprising and, seemingly, temporary (the market rallied!). However, this number reflects only one lockdown, in California, and 25 others have joined since then. It seems like we may have some way to go yet.

GDP growth is the bottom line, and the forecast here is no solace. It’s bad, very bad. Brokers are predicting -7.7% q/q real GDP growth for 2020/Q2. Nomura has -41.7%! The greatest Q2 estimate across the board is the optimistic Jefferies with growth dead flat.

Source: FactSet Economic Estimates

How Did We Get Here?

In 2019, in the span of eight months, we went from a hawkish Fed to a dovish Fed, perhaps the first sign that all was not well. Seven months later, we’re back at the barely positive rate of 0.25% that we became so used to after the 2008 crisis.

As we discussed a couple of years ago, the Fed has become hamstrung by their own policy and stuck in their Catch-22. We became addicted to their loose monetary policy, and we could not be weaned off. The markets couldn’t tolerate any real liquidity shock, and the Fed wasn’t willing to allow the market to correct.

Quantitative tightening quickly finished at the same time as the first of many rate cuts. Here we are back to 0.25%, and who knows if we’re here to stay. Now that the Fed has cunningly changed the “zero lower bound” to an “effective lower bound,” anything is possible (here’s to hoping they have learned the lessons of our Japanese and European coalmine canaries).

Some will argue that the COVID-19 pandemic could not have been foreseen, and the perma-bears harbingers were merely a broken watch being right twice a day. They had predicted 10 of the last two crashes, one might say.

Seems fair, but not so fast. There will always be a trigger to expose market dislocations. As Warren Buffett likes to say, “It’s not until the tide goes out that you realize who is swimming naked.” But the tide still needs to go out. The trigger may have been unexpected, but the risk and results were certainly foreseen by many.

Speaking of Buffett, his cash stash isn’t looking so irresponsible right now and BRK could be a very interesting stock to watch over the next 18-24 months. Now that there are plenty of companies on sale, we can expect BRK to rise from hibernation and begin the process that made them renowned in the first place. Be fearful when others are greedy, and greedy when others are fearful.

By Buffett’s favorite measure, may still have a way to go on the downside, though. Even after the market rout so far, we’re sitting at 1.03 times GDP for the Wilshire 5000. Right around 2007 highs.

For what seems like an eternity, people have been warning of the liquidity disconnect between bond ETFs and the underlying securities. Regardless, discounts to NAV have refuted this concern, and short of any volatility, the thesis was difficult to test.

Along comes COVID-19, and the dislocations appeared thick and fast. TLT, stuffed full of the most liquid of bonds—U.S. treasuries—began trading at unprecedented discounts. There were just no authorized participants stepping up with the balance sheet and desire to arbitrage away.

TLT

The story was the same in our next safest of havens, investment grade U.S. corporate debt (LQD).

LQD

Part of the problem seems to stem from the bonds themselves. The liquidity of these ETF products far outweighs the underlying and so it is not incorrect to propose that the more accurate price discovery happens here (and filters down to the underlying), as opposed to the converse.

We’re seeing problems in another one of our trusty bond liquidity measures; spreads between off- and on-the-run Treasuries are widening, all in the grasp for liquidity. We see the spreads between on-the-run 10- and 30-year bonds at multiples of the values from a month ago, and look at the 30-year…

The jump from on-the-run to the first off-the-run is the same as the jump all the way out to the tenth off-the-run. The whole curve sits four times greater than last month.

Correlations, something else we discussed previously, have hit the roof and all seems to be trading in the same direction recently. Especially within the equity world, the answer is obvious; it stems from the systematic ETF bid.

When an ETF purchases the bucket of underlying investments, it does so at the behest of little but a systematic weighting factor. There is no individual price discovery and with the rise of such products over the last several years, correlations have increased. Safe to say that if things move up together, they will also move down together. Why would there suddenly be price discovery on the way down? We’re seeing that as the S&P closes up and down with all sectors beneath it.

Where Do We Go From Here? Micro.

We clearly have a long way to go before normality is restored. AMZN and BRK remain very interesting stocks for the foreseeable future. AMZN is seeing Christmas-level demand and Whole Foods is getting ransacked with every restock.

Walmart WMT is another such brick and mortar champion and as much as the regime shift may be away from this traditional retail, grocery stores just can’t keep goods on the shelves right now. It doesn’t look like it’s changing, and it’s been a tumultuous six months for WMT, even while LTM and NTM earnings have stayed solid.

In terms of the market, we’re living in a rare time where realized vol is greater than implied. The record VIX of 82.69 may seem extraordinary, but, in light of the S&P closing -11.98% that day, it suddenly doesn’t look so extreme. A VIX level of 82.69 suggests average daily moves of just 5.21% over a 30-day period.

The 14D Average True Range (ATR) as of March 24 would imply an annualized volatility of 118%. The 1M ATR gives an annualised vol of 99%! Suddenly vol looks cheap.

The trade here is (was) long Gamma, but vol moves quickly and this is a rare inversion. With the Fed wholly committed to dampening vol and pumping the market with soothing liquidity, it can be expected to revert.

What may be the more interesting areas of focus, and decidedly more forward-looking, are brokerages. With volatility usually comes increased trading, wider spreads, and increases to the top and bottom lines of those in the middle. Tradeweb (TS) sits in the sweet spot here, playing in several asset classes, with low leverage, solid margins, and strongly valued earnings. Their Q1 report released on May 7 is one to watch for.

Where Do We Go From Here? Macro.

From an economic standpoint, it looks like pain ahead. PMIs from around the world are dipping into uncharted territory and all are pointing to contraction in GDP. China was the first to go, printing a Manufacturing PMI of 35.7. Non-Manufacturing is even worse at 29.6 with the forward-looking New Orders even lower at 26.5. All deep in contraction territory.

The U.S. is at a lag in terms of timeline, so we can expect March to be the one to look for. Flash prints have Manufacturing holding strong at 49.2, just in contraction territory, but still some way from the 43 print that would suggest overall U.S. GDP contraction. Services were ugly though, flashing at 39.1 and missing consensus estimates by some distance.

We are often told an inverted yield curve precedes a recession, but in reality, it is the re-steepening that we are waiting for. Usually a hurried Fed easing gives us the bull steepening that signals trouble and the inversion can be many months (even years) before.

Let’s look at it now; it’s not pretty.

Are we headed for a recession? Almost certainly. Will the curve steepen from here? Quite possibly. QE has previously been bearish for the long end as it increases inflation expectations, and with the Fed still holding rates above those globally, there may be room to fall at the short end. Either way, steepening is something to keep our eye on.

Negative real rates are looking like the only way out of the debt bubble, and with even bigger deficits to come after the U.S. is finished with its COVID-19 stimuli, we should expect them here to stay. The Feds last two forays into positive real rates have come at some cost…

What can we expect to perform well with negative real rates? Hard assets. Gold has long been touted in these times, as negative real rates erode cash and bond value. Whether gold is quite that haven is for another discussion, but copper could be in for ride once this crisis ameliorates.

While far from a precious metal or haven, China’s industrial resurgence as this all settles should put a nice bid under copper. It has taken quite the punishment in recent times. Couple that with negative real rates being traditionally bullish for commodities (as it lowers the carrying cost of inventories), and you have one to watch.

The overquoted Mark Twain quip applies here more than ever (c’mon, we have room to pull it out once more): “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Just like before, historical correlations are just that, historical. Now it seems everything moves in the same way. Be careful.