Market Thinking

making sense of the narrative

Market Thinking February 2020

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The fundamentals of Corona Virus matter less in the short term than the reality of the official response to it. Equally the presumed impact on earnings is less important than the technical selling, profit taking and straight out panic selling that occurred in the last week of February. Value is undoubtedly appearing, particularly in the ‘theme’ stocks and sectors where traders have pushed a global economic collapse narrative. Patience however is necessary for the market mechanics appear to be suggesting that the traders are succeeding in converting long term investors to their narrative and there remains a near term risk of further ‘profit taking’ in risk assets generally, after what was after all a very strong 2019.

In the previous edition of Market Thinking we discussed the importance of avoiding distressed selling when trying to buy into oversold markets and noted that we needed to not only see a slowing in the rate of increase of Covid-19 cases, but also how the markets themselves responded to it. During February we did start to see some slowing in the rate of growth of cases, certainly in China where the overwhelming majority of cases are to be found and mid-month the markets started to stabilise and, tentatively, start to unwind some of the more aggressive ‘anti growth’ trades put on in the previous month, with cyclical stocks recovering versus defensive stocks and in the factor universe we like to watch, value factors and size factors starting to pick up versus momentum and low volatility. That all changed in the last week of February however, when, as noted on the blog, it looks like a spike in buying US treasuries triggered something of a risk parity unwind similar to previous episodes and the Vix implied volatility index exploded to the upside (see chart). This in turn inspired the short term traders to put on aggressive deflation trades once more, blowing the tentative stabilisation out of the water. Interesting to note that the Hang Seng, which had recovered sharply in the first half of February from its January sell off on the basis that the virus was not taking hold in HK has given back all those gains.

A lot of this however, feels like Q4 2018 when the risk parity selling delivered a massive rotation between equity and debt and the macro punditry declared the markets were forecasting a recession and then positioned accordingly for another round of selling, only to be hit by a reversal at the close of the year. Back then, the Vix went from 20 to 35 and back again over a two week period. At the time of writing it has just gone from 15 to 47 and back to 33 in a similar time frame, reminding us that much as we crave an economic narrative, sharp moves in markets almost always reflect the market mechanics in the markets themselves. We suspect however that it is as yet too early to commit to the obvious areas of value, not least because just as the biggest economic risk from the Covid-19 virus is likely to be the exaggerated response to it, so the bigger risk to markets is not going to be any temporary economic slowdown, but rather the panic and distressed selling in response to market weakness.

The proximate cause of the sell off in February was a bad PMI number in the US on Friday 21st February, reflecting the disruptions cause by Covid-19, and the sudden and seemingly unexpected (to some) spread of the virus to ‘the west’ with an upsurge in cases in Italy over the following weekend –  leading to the big spike in volatility and disruption to markets happening when markets opened on the Monday. Never mind that the PMI was never going to be good and that the idea that the west was somehow immune was never credible, in circumstances panic, be it in markets or newspapers, feeds upon itself. The New York SE FANG plus index dropped 15% in 6 days for example and as our good friends at Redburn point out, in the last week of February we saw the fastest 10% drop from an all time high in history.

However, it is always worth remembering that the ‘record’ movement (in this case down) requires the set-up in the first place. Just as the strong annual returns of 30% plus in some cases reported by investors in 2019 owed a lot to the sell off and general weakness in equities in q4 2018, so the fall at the end of February required an element of momentum in equities that had up until that point tended to shrug off ‘bad news’. The ongoing issue of  risk parity structures that essentially outsource equity/bond allocation to algorithms means that a sell off in equity is as likely to be triggered by an independent reason for a rally in Bonds as anything to do with equities themselves. The fact that the yield on the US 30 year bond yield broke its all time low on the 20th of February (the day before the PMI being blamed as the trigger) partly reflecting hedging of US long dated corporate bonds to Taiwanese investors, means that it could actually have triggered the market mechanics described and thus the sell off actually might have almost nothing to do with Covid-19! The fact that TLT, the ETF that tracks the US long bond is currently at an all time high certainly reinforces the feeling that this is an aggressive bond equity rotation.

Meanwhile the interwoven layers of hedging and derivatives can have a magnifying effect as hedging makes movements larger rather than smaller, especially where leverage is involved. One small example of this to consider is that of famous investor Bill Miller, who at Legg Mason beat the S&P500 15 years in a row. Running his own shop now and with a strong value bias, his mutual fund returned over 30% last year while his hedge fund returned over 100%, the latter largely because it was 3 x leveraged. Good for him you might say and we are certainly not picking on him in particular, but it seems pretty obvious that with a renewed attack on cyclical stocks – especially energy, where he has some major stakes – that at the very least the leverage is going to be collapsed making sellers into markets with few buyers.

Chart 1. A classic Risk parity spike in Vix triggers panic selling in last week of February

As the chart shows, the spike in Vix is even bigger than the one in February 2018 that was caused by a market failure in what was effectively a short Vix ETF and also the year end squeeze at the end of the Q4 2018 risk parity rotation panic. In fact, Vix is currently at levels not seen since the Euro crisis of 2011, having almost hit 50 at the end of the month. It is rare to see the Vix go above 50, let alone for any sustained period and to be honest this all feels like q4 of 2018, when market mechanics pushed bonds up and equities down 20% respectively. This time, the virus and the global trade effect provide a more logical narrative, but the size and shape of the impacts point to trading positions being unwound by algos.

In other, more leveraged, markets traders pushed the Covid-19 equals global recession playbook aggressively. Oil was down over 15% at one point for example and it was also interesting to note that the trade weighted US$ was off over 2% – which is a big deal in that world – primarily as the Euro spiked sharply higher. This is consistent with an expectation that the Fed will ease rates in response to Covid-19, which, as ever, means almost nothing in the real world, but is important to the traders playing spreads at the short end of currency markets.

So, what to do? We suspect that traders will probably be closing out some of the bigger, more leveraged, negative bets on so-called risk assets, but are concerned that there has been some longer term damage to some of the technicals, in effect that a number of longer term investors may have been motivated by recent events to redeem equities and high yield bonds and switch to cash and that this will present a hangover for markets for some time. Certainly when looking at the world through our factor indices we see only momentum as an equity factor holding its long term trend – and then only just. But value is undoubtedly to be found, not least in companies with strong long term positions and solid enough balance sheets to allow them to survive a cash burn while the virus puts economies ‘on hold’ for a while. Moreover in the upside down world where we seemingly buy bonds for capital gain and equities for yield, the fact that the price performance of, for example, BHP over the last two years is now effectively zero but the total return is almost 20% is something that total return focussed investors should and will be focussing on, especially as US 10 year yields are now barely 1%.

The negativity on global growth is hitting commodities of course and currencies, such as the Australian dollar, which had, in any event,  been in a downtrend since q2 2018, and has just hit new 10 year lows against the US$, presumably on the basis that China will never buy any more coal or Iron ore ever again. It is not quite that cheap against the Euro, but is still off 30% from its highs and is as competitive as it was in the early 2000s – something that the UK will be interested to note with respect of future trade deals. Equally, while the CNY is a little weaker overall year to date, the relative strength of the RMB against the Aus $ continues (+7% year to date) which makes Australian goods and services (and assets where allowed) ever more attractive to China when it does eventually restart the engines.

Australia is symptomatic of the anti Cyclical stance being taken by traders at the moment, as are Emerging Markets generally. They both represent a case of cheap getting cheaper and while both are (and should be) on our radar at the moment, the prospect of further technical and distressed selling means we are happy to wait a bit longer. The positive aspect of course is that cyclicals and anything China related began the month recovering from earlier negativity so are still hardly expensive, while in the US in particular, there is still a lot of ‘profit’ to be taken. We have also seen a lot of kitchen sinking starting to happen as companies adjust guidance based on ‘the virus’. Until a week or so ago, stocks like Apple barely moved on a downgrade. Now, with the momentum broken they have dropped between 15 and 20% in short order and it will be interesting to see how quickly they rally, if at all. Some will, of course, but others, shorn of momentum risk more meaningful medium term weakness.

Bottom line, the sell off at the end of February had a strong technical feeling to it and while the narrative of Covid-19 and its impact on the global economy was certainly more plausible than the vague talk around Fed tightening that appeared to trigger a similar selloff in equities and rally in bonds in Q4 2018, we suspect that the two occasions are more similar than many would accept. There is now some strong value around, not least in cyclical and commodity related areas which are pricing in a permanent loss of economic activity rather than a temporary one, but experience also alerts us to the likelihood of some more distressed selling and profit taking in the weeks ahead. It is likely that most of the asset allocators are now neutral and that traders’ leverage on the downside has also now been unwound, which means that the remaining risk is from selling by long term investors looking to take profit and perhaps buy real assets. Ultimately however, the vanishingly small yield on bonds will drive the long term investors to allocate back towards long term cash flow positive equities, many of whom are in so called economically sensitive areas.

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