Markets are Skinny Dipping, but the Tide has Not Gone Out
Warren Buffet famously said that “Only when the tide goes out do you discover who’s been swimming naked.” Buffet humorously describes how any investor is successful in a bull market, but when the market drops few remain standing, that is, not swimming naked. The recent global outbreak of COVID-19 has led to unexpected market turmoil, leaving many funds and speculators scrambling for liquidity to cover losses or meet margin calls. The United States and other global economies have suffered greatly following the spread of the virus, leaving them to face its long-lasting effects. However, this only comprises a small part of this discussion. Signs of the weakening American economy have appeared sporadically throughout the last 7 months, with COVID-19 highlighting the difficulties and inefficiencies in the cogs of the American economy.
In July-August 2019 we saw a mountainous rise in negative-yield debt, inverting yield curves and making many investors cautious about an upcoming recession. Moreover, given that usual safe havens such as the United States and Germany were no longer profitable for investors, it pushed them to look towards emerging markets such as Greece and other Eastern European countries. One of the biggest surprises, and an example of the odd market conditions, of the summer was when 10-year Greek government bonds dipped lower than 10-year Treasuries. This indicated that investors were willing to accumulate more risk to ensure a positive yield. Nonetheless, this investor behavior was not limited to government bonds and included buying high-yield corporate bonds for better returns. The problems surrounding high-yields are discussed in a previous article, but it is revisited in this discussion to illustrate the challenges they face and threats they pose under the current market conditions.
Carl Icahn voiced his concern on this topic in 2015, during a conversation with BlackRock CEO, Larry Fink. Icahn is not alone in making the assertion that fund managers are assuming higher risk to provide more appealing returns to their investors in the years following the 2008 crisis. However, this extremely large collection of high-yield corporate debt will mirror the consequences of the sub-prime mortgage disaster.
Similar to Icahn’s idea, the high-yield corporate debt survives, reaps the benefits, and becomes overvalued in a bull market, satisfying investors with tidy returns, however, as the economy tightens up, with rising interest rates, or is shook — as it currently is with COVID-19 — high-yields become less attractive because of the higher risk associated with them, leading to declining prices. The iShares iBoxx High-Yield Corporate Bond ETF (HYG), illustrates Icahn’s argument. HYG reached a 10-year high, hovering above $88 a share, before gradually losing approximately 20% in one month. HYG’s decline is not necessarily surprising but should be ominous of further financial troubles in the American economy, as companies begin to default under declining market conditions.
The September following the summer’s bond rally experienced an unanticipated surge in the repo rates, which required the Federal Reserve to inject $75 billion into the markets and calm liquidity demands. This spike in the overnight borrowing rates resulted from companies attempting to meet their September 15 corporate tax deadline and Treasury coupon settlements. Without context, this appears an isolated event, however, the Federal Reserve anticipated that the $1.3 trillion in bank reserves would satisfy any market shocks. It is known that $1 trillion is tied up in regulatory and liquidity requirements, with the $300 billion serving as a safety net. Nevertheless, the September events in the repo market raise questions about market liquidity, even with the help of a 30% buffer.
Currently viewing the markets, the liquidity problems are evident, with wide bid-ask spreads across all asset and derivative classes, threatening market stability. With the sharp decline in the stock market and COVID-19 putting the United States’ economy on hold, a lot of repairs and time will be needed for normal market conditions to return. The United States is following a delayed timeline for COVID-19 making it extremely likely that volatility will not cease in the near future, further dragging markets down. In turn, companies would require a larger recovery period reducing the efficacy of the 90-day delay of the tax deadline. Ultimately, this could result in a liquidity squeeze similar or worse than that this past September.
Nevertheless, despite the repo market shock, the markets experienced a gradually yet steady ascent in prices, up until the end of February. With the spread COVID-19 and the worsening conditions in Wuhan, China, investors grew weary of the outlook of the United States economy with the virus reaching various countries across the globe. The volatility in markets has persisted resulting in a rough 30% drop in the S&P 500, from an all-time high of nearly $3,400 to $2,400 a share.
As was aforementioned, given the explosive transmission of COVID-19 and the subsequent shutting down of New York City, markets reacted wildly, leaving many traders and investors exposed leading to extreme selloffs to mitigate losses and acquire cash to satisfy margin calls. Moreover, many relative value trading firms suffered due to the startling liquidity problems in the Treasuries market, one of the market’s most liquid assets and a safe haven during uncertain times. Relative value traders take advantage of price discrepancies in securities that very similar or related to one another, by buying one asset and selling the other, profiting the difference in prices. Firms such as Millenium Management, ExodusPoint, and others specialize in relative value trading and may be under stress from current market conditions.
Currently, the conversation across the United States’ markets is how can the world’s largest economy recover from the current and continuing financial struggles. The nightmare of COVID-19 has only begun in the United States, with only 125 per million tested, according to a New York Times report on Tuesday. Moreover, with 16,638 cases already reported in the country and with the virus set to peak in New York City in roughly 45 days, as Governor Cuomo explained, the United States is expected to battle the virus at least till May. Some, such as President Trump, fear that the virus may still be troubling Americans well into the summer, worsening the financial outlook. With markets already reaching fearful lows, investors should expect market volatility to persist and the economy to further suffer.
COVID-19 does not foretell an Orwellian future for the American people but it will distort the reality they have been comfortable with. China, initially, failed to contain COVID-19 and ultimately needed to impose indiscriminate quarantine, devastatingly effecting its economy. Yet, China intelligently maintained its focus on the virus understanding that economic stimulus is a secondary step in the recovery of the country. Nevertheless, China will require time to regain its momentum and reestablish a semblance of normality in daily life and the economy.
Contrary to China, the Federal Reserve relentlessly employed extreme monetary policy, dropping interest rates by 125 basis points within one week, and injecting over $1.5 trillion in the markets, with the markets continuing to drag downwards. Consequently, the Federal Reserve has used the majority of its arsenal leaving it with few options to refresh the economy after COVID-19 is contained. Unfortunately, there is little that can be done about the past, with the Federal Reserve’s best hope being supporting the workers and businesses that have suffered as a result of the virus to establish a basis for a smoother economic transition after the pandemic subsides. Economists and investors alike, suspect that a recession is yet to come, with further drops and volatility anticipated in the market as COVID-19 develops across the country. The United States, and the rest of the world, is most certainly headed towards–if not already in — a recession and can only move forward by attempting to make the transition into this economic era as painless and costless as possible through further quantitative easing, fiscal policy, and support of the employment sector. Once the tide of COVID-19 goes out, those not swimming naked will be the best-positioned.
In 380 B.C. the Philosopher Plato published his landmark work: The Republic. In it he presented the Allegory of the Cave, which he used to explain the issue of truth and deception in his society and his ideas ring true to this day. We at Plato’s Cave believe that the overwhelming majority of the world’s population is trapped in the metaphorical cave of fake news, bent truths, and flat out lies fed to them by the financial world. It is our intention to liberate the masses from financial illiteracy and falsehoods and guide them out of the cave into the light of truth, one article at a time.
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