Navigating markets in time of crisis (Part IV): the roads ahead & resolution

Disclaimer: nothing in this article constitutes a recommendation or advice to buy or sell a security of any kind by the author. Trading in financial instruments has many inherent risks and readers should consult with specialists for any investment decisions.

A month ago, few expected what we witnessed in March and yet it did happen. Only 10 days ago few expected (including the US President) the dire prediction of the death toll released by the US administration this last week.

In fact, the events have been unraveling so fast that it is probably only a week or so that pundits and analysts have diverted away from the V-shape rebound projections and started to grasp the depth of challenges facing us in months ahead.

The first of this series of notes was published on Feb 24th and I put a 40% probability on a negative outcome: the global spread of the virus and stress in financial markets. In the last one, on March 22nd I emphasized that in light of the data, the worsening of the situation in the US would exceed the general expectations at that time. We have highlighted repeatedly that it is particularly important for policy makers, investors and analysts to think in terms of spectrum of outcomes rather than a specific narrative taking us from today's situation to a given point B.

 It is highly recommendable that investors and policy makers thing in probabilistic terms. This is something that as human's we are not wired for and requires conscious effort and discipline. (Had they done so 2 months ago we might not have been at this point)

First, some welcome good news

Before we head into the range of outcomes ahead, let us underline the fact that the risk of contagion of a steep economic decline into a systemic problem for the financial system subsided a lot.

Fed's actions - intervention in repo and treasury markets, extension of purchase programs and the addition of new classes of assets, provision of ample USD swap lines - were timely and needed actions to take the systemic risk away.

Additionally, we have observed what seems to have been a rapid (and healthy) deleveraging in some areas of the market (basis trade in treasuries and the short volatility strategies), helping reduce tail risks.

This chart shows that while the S&P500 is at the same level than mid-March, the 1 months constant maturity VIX futures basket (a measure of tail and convexity risk) is off by 25% since that time (from 60 to 45).

Yet much fundamental uncertainty remains.

What is the spectrum of outcomes ahead?

At this juncture and in light of the information available - data and commentary provided by scientists and specialists - we can focus on a framework with 3 outcomes (we can create more detailed ones but this one is meant to be both as useful as possible and as succinct as permissible):

• The good outcome: medical breakthrough in next weeks and a rather speedy return to pre-crisis "normal" way of life and activity
• The progressive outcome: self-isolation and social distancing will help control and suppress the spread in the coming months and various measures will permit to progressively pick-up the economic activity to some extent while we await the vaccine (probably 8-10 months away at best)
• The complicated outcome: this would be caused by the unknowns/unknowns which are by definition not predictable. Here are some examples: while the CoVid19 is according to specialists not a "mutation-friendly" virus, the probability for it to mutate is not nil. One can only fathom the extreme challenges that dealing with a mutation would cause. Or what if in a few months, those who were infected and survived the virus start exhibiting health side effects and complications while the system is still dealing with the pandemic. Generally speaking, any other secondary events with strong negative impact could cause this outcome.

The table below provides a snapshot of these outcomes and some timelines and details corresponding to each of them.

From an investor's perspective the question is how to position oneself so that no matter what scenario materializes there is a potential for achieving returns while avoiding substantial losses.

The answer to this question is far from self-evident, because as mentioned in my previous notes many other inputs are required. Some of those inputs are known at this stage - such as Fed's new programs and the $2.2 trillion package - while we will only get to know other measures in weeks and months to come (new emergency measures, fiscal and taxation legislation).

Here are some thoughts that might be helpful in addressing the question of positioning

No matter which outcome is ahead of us, it is useful to categorize the effects on economy (industries and businesses) into two:

1. Irreversible loss: essentially the demand that did not materialize and can not (or will not) be replaced in the future
2. Controllable loss: supply and demand that can (or will) be artificially replaced or boosted (via fiscal and other policy)

• Whatever outcome is ahead of us - even if it is the good outcome - the irreversible losses that have incurred (akin to a sunk cost) will not be made up for. This means some assets will settle into a new thershold/range. Do not expect them to be back to their recent all time highs.
• Similarly, whatever outcome might be ahead of us the measures taken by Central Banks and governments so far are unlikely to be reverted, so their effects (both positive and unintended) will also be part of the world ahead of us. For instance "quality" fixed income instruments have an inherent floor on them as the Central Banks are buyers now.
• In case we face a good outcome, it is very likely we will see a relief rally (risk-on) driven by investor psychology and relief, after facing weeks of uncertainty and pain. This will likely to be followed with a longer process of in-depth appraisal of the effects of what we have lived through and by determining the new "value" for various assets and securities, where the market would settle.
• No matter which outcome we face, it is very likely that in the short and medium-term interest rates (in the developed economies) will remain low (scenario I) or fall further (if we face scenario II or III)
• In line with my previous notes, the outlook for precious metals under any of these scenarios remains positive. Albeit, if we have a good outcome ahead of us, a correction is likely, but the downside remains limited if we look at pre-crisis levels.
• I am not an equity investor and I have little idea what valuations might look like going forward but it is important for equity investors to note that expectation for dividends in 2021 on S&P500 stocks are cut to $33.5 (in index points) versus $63 pre-crisis. That is a 46% drop. That brings S&P500 dividend yield for 2021 to approximately 1.40%. That is near all time historic lows but then again if rates go to zero might a yield for which investors are ready to take on equity risk(?).
• Finally, in case we are faced with outcome I and II, no matter where asset prices are headed (sideways like the 60s or further down like Japan in 1990 or a strong V-shaped rally), there is a very high likelihood is that risk premia will come off, i.e. volatility and option prices will drop in the medium term. Why? Because: a) as we get more information on business and government action uncertainty fades, b) humans are resilient and we adapt both psychologically and operationally to new environments.

To highlight this: it took the market (Dow Jones and S&P500) over 2 decades to find their pre-Great Depression level, however the general level of volatility dropped in matter of month to a year despite a prolonged period of economic downturn and hardship 

At LFC after having navigated through March (thankfully successfully) we are preparing for these types of opportunities in the weeks to month to come. Feel free to reach out if you want to know more.

In conclusion, investors are well served in these times by avoiding an emotional approach (we are all human after all) to markets but also by avoiding very strong directional views (they will be a time for that hopefully soon). When you put a position on make sure to have a plan B (and may be C and D!) in place should it not turn out as expected. (Options can help alot with devising such plans)

Please be safe and vigilant, we have still - at least - a few challenging week ahead.

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