While appreciating the tranquility of the forest beside a stream, the wise and veteran samurai tells the young warrior:
‘If you sit by the river long enough, the bodies of your enemies will float by’
I’ve long wondered what this quote meant, but I think I’ve finally figured it out.
It is a quote about patience.
It’s about taking comfort in the fact that as you train and prepare yourself for battle, your rivals will eventually die even if you do nothing, sitting by the river.
It simply means to be patient and focus on improving yourself day by day.
The Scene by the River
I felt compelled to come out from a hiatus of writing given the recent shocks in financial markets. If you’re reading this you’re probably already familiar with the recent events.
By various quantitative measures of the recent moves across in stocks, bonds, currencies and commodities, late-February/March 2020 is going into the record books of one of the most turbulent months in Wall Street history.
The huge swings in equity and currency markets daily felt reminiscent of a crisis environment as volatility rose across all asset markets and traditionally-perceived safe haven assets failed to deliver.
Looking at the classic indicators of market volatility, the VIX & V2X has surged back to 2008 Global Financial Crisis (GFC) levels:
The ratio of S&P 500 near-term and mid-term implied volatility has surpassed previous episodes of market crises such as the Eurozone sovereign debt crisis, the August 2015 Renminbi devaluation scare and the 2018 ‘Vol-pocalypse’. Notice how it’s staying elevated for a while as compared to previous times when it rose above 1.0:
You can easily see how wide the front-end of the term structure has moved over the week:
And since 21 February when the curve was still in contango (light-purple at the bottom):
I wouldn’t pretend that I wasn’t shocked by the recent moves. It was a lot swifter than I earlier anticipated.
I wasn’t hurt much as I was defensively positioned, but I certainly see the numerous bodies as I sat by the river (systematic risk parity strategies crushed, bank margin calls, etc). Many electronic trading platforms couldn’t function properly at times throughout the week (yes including big investment banks).
If you’re a money manager or a professional advisor and you’ve been drastically affected by the recent moves, you haven’t been doing your job well.
There were many signs of optimism and of an over-extended market coming into the Lunar New Year. Market internals were stretched, and general sentiment went from the doom and gloom in 3Q last year (worldwide social unrest, recession fears, ‘repo-calypse’) to all fine and dandy leading up of the signing of the ‘Phase One’ deal.
February’s BofA’s Fund Manager Survey (FMS) indicated that professional money managers were throwing in the towel from last year and chasing the equity market rally (exactly at the top):
Equity markets hardly saw daily moves of >1.0% since late-October, which could be seen in low and declining average true ranges (ATRs). Such conditions usually encourage a complacent and gradual systematic build-up of short-volatility-like exposures.
Initially, I thought that the catalyst for an adjustment in equity market valuations would be the signing of the Phase One deal between the US and China (classic buy the rumour sell the news), but it could’ve been any other event as well.
Market participants typically attach an explanation to market moves and reactions, and over time narratives are created (however most aren’t true!). At any one point in time there are numerous narratives and some become more dominant over others as more participants latch onto them.
At present, the spread of Covid-19 beyond China is now the dominant narrative in markets worldwide. Price action now follows the official data/statistics of the virus’ and the reactions of authorities and policy-makers to the outbreak.
When there’s a Gestalt shift in the markets, a widespread change in the psychology of market participants, the resultant moves can be swift and brutal. A questioning of previous assumptions is taking place.
As what Arthur Miller wrote in ‘The Crucible‘:
‘Until an hour before the Devil fell, God thought him beautiful in Heaven’
The Flowers yet to bloom
Given the focus on the trajectory of cases (pace of new cases) and what happened in Hubei and South Korea, all other kinds of data, whether official or unofficial, are now being examined and analysed through the ‘pandemic’ lens.
And at this moment, it doesn’t seem to be improving soon, particularly in Europe and North America (the latest in NYC).
There is a high possibility of severe economic distress worldwide. Since the epicentre of the outbreak has moved from Asia (China, South Korea) to Europe, the stress on supply chains and the demand side of the global economic equation will continue to stay under pressure. We could be looking at something unprecedented – an economic pandemic that is caused by attempts to flatten out the epidemiological curve.
The below diagram from Richard Baldwin illustrates the current dynamic:
Governments been responding with fiscal packages to cushion the impact of quarantines and restrictions on companies, and they have to do more as corporations worldwide draw down on credit lines, cancel investment plans and consumers dig in and spend less.
The heart of the US economy, domestic consumption, will take a hit as more areas of the US goes into lock-down mode. This will affect GDP for at least two to three quarters, and markets are sniffing this out.
There is a bull re-steepening in the US Treasury yield curve after an inversion from the frond-end (blue line the latest compared to the inverted curve last three weeks), which indicates that more capital has flocked into the short-end.
Expectations for the Federal Reserve to do more has increased after their emergency -50bps rate cut, with markets expecting the Fed to cut by at least 75bps:
As for the European Central Bank (ECB), it’s likely that they have to intervene more given that yields of Italian BTPs have risen across all tenors:
This is not a healthy development as it could cause an implosion in the peripheral financial system. It doesn’t help that growth is likely to get worse as more investment and spending is curtailed on the continent.
Overall, stabilisation in markets could occur once the outbreak is perceived as being brought under control. Sitting by the river is a viable course of action if you can’t be tactical and nimble. Going forward, there are two things we could do:
(i) Watch the Generals of the equity market. These are your FANG and software services stocks, as well as semiconductors. They have been the leaders of the equity bull market over the past few years, and their relative performance going forward will offer clues as to the stock market cycle.
Most of them have rebounded after collapsing to their long-term moving averages on their weekly charts.
Taiwan Semiconductor Manufacturing Company (TSMC):
Also, it’ll be good to keep an eye on financials as they remain the heart of the plumbing of the system. But I personally think that there is leeway for policy-makers to tweak regulations and provide liquidity to ensure the vital credit channels remain operational (more repo operations on the way).
JPMorgan Chase (JPM):
Cyclical markets like Japan will probably see an economic slowdown for the rest of the year as the demand side shock hits the economy. The Nikkei 225 Index has probably topped out for this cycle:
Watch sentiment indicators closely and how market prices react to negative developments and news.
(ii) Look beyond the current slowdown
While not likely to happen so soon, there could be a time when the world gets over this, and financial markets switch their worries to other more dominating narratives. And this whole episode will be another turbulent chapter in human history.
With bond yields likely to remain low and inflation data perceived as low as long as oil prices do not rise too much, equity market multiples may recover once sentiment improves.
For those who have the fortitude and faith in humanity, they could be handsomely rewarded for taking a step into the dark. Airlines anyone?
The View of the Forest
At times, we all miss the forest for the trees. It’s important to take a step back from the flowers, pebbles and rivers and gaze where the sun is setting beyond the horizon.
As I stepped back and take a look at the world, I see a paradigm shift.
Monetary policy-makers are increasingly looking like they are fighting the last war, which means that should the current situation deteriorate, we’ll enter a new policy regime.
A new monetary policy-making regime
Inflation expectations have collapsed globally, and central banks are desperate to maintain their credibility and secure their legacies.
Fed member Lael Brainard’s recent speech offers clues as to how the Fed will conduct policy moving forward. In summary, measures such as average inflation targeting and yield curve controls are likely to be employed in the US.
As for countries already with negative policy rates (Japan, Europe), their policy toolkit will gradually evolve to dual-rate regimes, and in fact, the ECB’s latest move (TLTRO III) announced by Madame Lagarde suggests a start of something of that sorts. This new measure encourages ‘carry trades’ by commercial banks with the ECB to lend to businesses, and it encourages a rebuild of capital.
Fund manager Eric Lonergan has an insightful post for those interested to understand more about this new policy toolkit.
A new world order
The outbreak of Covid-19 flashes out the fragility of the current system that we live in. Monsieur Charles Gave highlighted this in a brilliant article recently, where he wrote:
‘The more optimized a system is, the more fragile it potentially becomes. Ming dynasty porcelain is undeniably finer and more beautiful than any tin cup. But what the tin cup gives up in beauty, it makes up in resistance. Clearly, the current Covid-19 uncertainties are revealing the global system’s fragilities, both short term and long term…
As Frédéric Bastiat never tired of saying, economics is all about “what is seen, and what is not seen.” In recent years, what markets have seen is the rise of profit margins permitted by globalization, and the adoption of the platform company model. What markets have not seen so clearly is the rise in fragility that came with the optimization of supply chains: fragility as supply chains became ever more dependent on China; political fragility as Western workers (and voters) felt increasingly squeezed out; and financial fragility as Western governments continue to increase budget deficits, passing on to future generations the cost of running today’s welfare states.’
Monsieur Gave forgot to highlight the fragility of the geopolitical landscape, which I’ve found both interesting and troubling at the same time while examining its evolving dynamics.
The solidarity between European countries is severely tested by this coronavirus outbreak. Italy only received help (medical supplies) from a plane from Shanghai, and Italians can’t help to feel abandoned after years of struggling by themselves.
Trusts between countries worldwide have continued to breakdown after trans-Pacific and trans-Atlantic trade tensions and more recently, the collapse of OPEC+. The pullback of America’s global leadership since the Bush Administration is starting to have its impact felt.
I’m of the opinion that the world is not only going multi-polar, but becoming regionalised. The trend of globalisation is simply reversing real-time.
Amid this breakdown of cooperation and coordination between countries, the odds of currency devaluations and ‘beggar-thy-neighbour’ policies are a lot higher. This was alike the times of the Great Depression in the 1930s, where politicians blamed one another for their countries’ ills.
Countries less reliant on trade are in a good position and those that have greatly benefited from globalisation over the past four decades are the ones that will be the most impacted.
After the dust settles, corporations with global supply chains are likely to rethink their operational setup to lower their vulnerabilities (if management doesn’t, shareholders probably will pressure them to do so).
This has huge implications for business, wages and inflation and they are likely to be structural shifts.
Additionally, a complete rethink about the nature of work (does it have to be at an office for screen-based professions?) as more people work-from-home will change work practices. Companies that allow ‘social distancing’ may benefit and become part of our everyday lives, structurally allowing them to be valued at higher valuations.
I personally think most of the existing practices (9-5) are relics of the industrial revolution…
Thanks for reading. Stay safe and in good health out there-
Follow me on Twitter: @keanferdy.