'we are still, at this stage erring on the side of caution. In our opinion, the possibility of another large loss is still on the cards.'
Markets taking a positive tone today as the Central Bank Stim Shots start to have an effect. The big question is will this be enough to, at least, draw a line under the volatility of the last few weeks? We feel that the Stim Shots definitely help. However, as we have seen this week, the law of unintended consequences is now coming into play. The UK’s shot at Stim (ongoing announcements) only served to draw attention to the frailties of the UK economy. One which is based mostly in the provision of services. Services, in times of duress, are the first discretionary purchases to be left on the shelf. Service industries have no means of re-selling lost opportunities. Once the day, or time, of sale has passed and there is no sale, it is a lost sale. The markets woke up to the fact that the UK is a service economy and sold the Pound. The move this week was only just shy of the 13% drop on the back of the shock Brexit Poll in 2016. The Pound, like most risk assets, has since recovered slightly. But this goes to show the extreme nature of fear and the problems of investing in these volatile, momentum led markets.
Another point raised through a Bloomberg correspondent is a reflection on the fortunes of hedge funds, the Masters of the Financial Universe, stalking through Bourses with a Vaderesque veil of secrecy.
“Take that!” Mr Vader
“The coronavirus outbreak is costing hedge funds billions, as a massive dislocation across asset classes causes a breakdown in traditional relationships. In the past 10 days, bonds, stocks and even gold — a hedge against the prospect of central banks’ helicopter money — are falling in tandem. Funds that rely on computer algorithms and historical global macro trends are hurting.”
It is the case that all of their trade strategies, except probably Macro (the hedge funds behind the fall recent in the Pound) are just not working. Some bet on negative correlation relationships between Bonds and Equities, which until this week was at -0.84 (-1 is perfect negative correlation and +1 is perfect correlation). With this level of -0.84 correlation between assets, you can be long of one and short of the other. When the market moves in the way you expect, the returns come in from both sides of that trade and the “portfolio” is balanced. It is for this reason that we advocate holding both bonds and equities in balance portfolios. However, as the panic measures from Central Banks came in this week, stocks and bonds both fell in tandem. US 10 year yields more than doubled, a stunning comment in of itself. The correspondent also notes that as Bonds tended to be less volatile, the “long” bond side of the strategy was leveraged. However, bond volatility has been just as high as the equity market equivalent.
The correspondent finished up with the following:
“Ray Dalio, Bridgewater’s founder, famously said that cash is trash. Now, Dalio, who is revered in China, has to get associates there to dispel rumors that his funds have “crashed.” As we’ve argued, the coronavirus is turning all of us — people and companies — into hoarders. All we want is cash. The hedge funds that borrowed piles of the stuff to buy everything around the world can't be feeling too comfortable about the weeks ahead.”
So, even the “Dark side” has turned to owning cash and perhaps this is just an additional reason for the global dollar shortage. The liquidation of leveraged strategies would certainly account for these wild swings in the market. The problem with leverage is that in, a losing streak, there are losses that have to be accounted for. Margin calls would have to be met and money is lost, never to be returned. We have not heard about any stressed hedge funds going into liquidation yet. However, losses of the magnitude we are seeing in markets will have critically reduced the amount leveraged investors have to deploy. Unless they can replenish their coffers with additional investor funds (anyone willing to put money in a hedge fund right now?), such large amounts of leverage won’t be available again for some time. On top of that, if you run a prime brokerage business, the people that supply the liquidity for leverage trades, wouldn’t you be thinking about reducing your credit lines?
It would be interesting to see how much financial resource has been drained from markets and lost, once and for all. If the gross amount of investor funds have been permanently reduced by the crash and burn of the leveraged sector, surely the ability of markets to recover to previous highs has also been severely dented? This point also needs to be considered alongside the probability of absolute investor losses from companies going into default. My colleague mentioned that a CNBC news item detailed the absolute loss of 1,000 privately owned companies in the USA to date. He also mentioned that the same news channel said we should expect the “gating” (closure to withdrawal of investor funds) on corporate bonds funds…. Well discuss these points in another CVC.
Extreme moves?
M&G Plc, recently spun out of Prudential. The Company is responsible for managing billions of investment funds in all markets across the Globe. Unsurprisingly, it’s share price has fallen at breakneck speed over the past few days. The Investment Management sector will be continuously under the spotlight as they are the front line in the financial part of this crisis (see the last comment on funds being “Gated” – M&G has the biggest traditional style Sterling Corporate bond fund, by NAV, fund in the world).
However, the reason for the chart here is simply to show that a 63% loss in the space of a few weeks, can be a 41% gain in the space of a day (If we look at the peak to last close price, the loss is “only” 48%). It is one aspect of the market that should make us want to add some risk in our investment models. However, we are still, at this stage erring on the side of caution. In our opinion, the possibility of another large loss is still on the cards.
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About the Author
Peter Smart, Head of Investments
01534 488778
Peter has been involved in investment markets since 1985, working within the private client areas of two global banks and for 22 years as the fixed income specialist for the UK Wealth manager, Brewin Dolphin. More recently Peter formed part of the investment team at bridport in Jersey specialising in the provision of specialist, income focussed portfolio’s.
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