| 1. It is still all about the virus: optimists do not believe in a second wave; pessimists worry it could be devastating.
One of the many confounding things about the pandemic is that scientists do not yet really know how transmissible or deadly the novel coronavirus is.
We do know much more than three months ago. Social distancing works to limit spread, being outside is safer than being inside, wearing face masks reduces the chance of infecting others, while shouting, singing, coughing and sneezing all transmit the disease rapidly to those nearby –disadvantaging those who live or work, or must travel to work, in close quarters with others: think nursing homes, prisons, meat and poultry plants.
We also know that just as Covid-19 cases can increase exponentially, they can decline exponentially, rapidly reaching low levels if the spread, or R, is limited sharply to well below 1. That has happened in some countries, but not in America. Here, new cases of infection declined only slowly nationwide and have stabilized or even risen in recent days. And most of the population remains susceptible to infection. Globally, new cases are still increasing by as much as 130,000 a day. On mortality, it is reasonable to believe that the medical response to a second wave would be better in the US and Europe than the first time around, even without effective new drug treatments.
But we are in the middle of an experiment. Will behavior change enough to limit transmission even as economies reopen? It will not take much in the US to push the spread of infections back up above an R of 1. Curbing the disease without a return to the devastation of mass lockdown would then require effective systems of testing, tracing and quarantine.
2. Economic fundamentals reassert themselves: consumer and business confidence are what matter for spending behavior.
Pessimists about the path for the economy and earnings make two further arguments, beyond a resurgence of Covid-19. The first is that even the threat of further disease will put a cap on demand for the services that are the mainstay of advanced economies. It will take some while – maybe until a vaccine or effective treatment – to entice everybody back to previous levels of air travel, hotel stays, restaurant visits, gyms. The US and global economy will recover, but not to its previous path or anywhere close for at least two to three years.
The second argument is that underlying economic behavior will change, given the tremendous loss of jobs and incomes during the lockdown. Unemployment of 10% at the end 2020 looks good compared to the Great Depression levels feared in April. But it represents an economy that is far from full employment. In this view, the shock of unemployment and sudden bankruptcies, particularly of small businesses, has damaged the engines of growth. Risk aversion will rise, consumers will save more and businesses will hold off on investment. Corporate earnings will not recover to the extent now anticipated. Debt burdens will increase as inflation stays low, or even tips into deflation. And the longer the recession, the worse the scarring of the economy.
Others believe that the gloom is overdone. Friday’s labor market report was just a foretaste of good news to come. Strong fundamentals going into recession, especially in the US, mean that the economy is set to rebound just as speedily and sharply as it collapsed. The upside surprise from falling unemployment and rising output will in turn be self-reinforcing. Risk appetite among consumers and firms will return, just as it is coming back now among investors. Once again, the US economy will show its resilience. This is still a minority view. But expect to hear it more as data coming in will show more improvement from April’s low, whatever the medium-term outlook.
3. Policy is overwhelming: liquidity of historic proportions has been provided in the face of an economic crisis of historic proportions. Is it enough?
Massive liquidity provisions by the central bank, and a commitment to do more if needed to head off financial crisis, have supported financial markets in the US, Europe and other major advanced nations. That much is clear. Where there is more debate is whether central banks on their own have enough firepower going forward to promote a sustainable recovery.
Financial markets and, eventually, the economy more broadly were lifted by monetary policy during the decade after the global financial crisis. After a fiscal stimulus in 2009, budget policy in the US and – even more so in Europe – became contractionary and a drag on growth. That slowed recovery, but did not stop it. The Fed and ECB are now doing much more, more swiftly, to boost the economy, even straying into territory that they usually leave to governments. Fiscal authorities have also acted to support incomes and output.
The policy response is undoubtedly a big part of what has helped markets rebound. Will it continue?
In the US, partisan disagreement and the evidence that recovery began in May push back the chance of further fiscal support. Some fear a looming “fiscal cliff”: one-time stimulus checks have already been disbursed and much of this money has been spent; a temporary boost to unemployment insurance in the CARES Act expires at end July; small businesses have been given longer to spend the loans from the paycheck protection program (PPP), but the bulk of the money has gone out of the door. And state and local governments are busy cutting spending to offset lower revenues from recession.
The bottom line: the Fed will need to keep its foot on the accelerator to offset these factors. That will likely support financial markets, but the real economy may be more sluggish for longer, and earnings lower, than many now hope.
4. Investing in uncertainty: retail investors lead the charge up.
While today markets seem calm, resilient and optimistic, as investors it is hard not to worry about the potential aftershocks from this period on our economy and society.
Institutional investors are trying to be thoughtful, longer term, and adjust positioning and investment themes for a new risk paradigm. Yet, the rest of the market – the majority – is on a high speed, momentum-driven ride to the top. The market continued to reward those stocks considered less favorable by most institutional investors. Morgan Stanley indicated that this past week has been the worst for the spread between crowded longs and shorts since they began tracking the data in 2010. The top 50 crowded shorts outperformed the S&P 500 by 5% and hedge fund investors were busy covering short positions – probably in anticipation of more pain if the markets continue in this direction.
Meanwhile, a dichotomy continues in the market. Work from home stocks like Zoom and Slack continue to be favored. Slack has been an attractive proposition as the pandemic forced companies to look for new remote collaboration tools. Slack stock had risen approximately 69% year to date prior to its fiscal first-quarter results this past week, easily outperforming the 9% gain for the S&P 500’s software and services group and even the 43% gain of the BVP Nasdaq Emerging Cloud Index (an index designed to track the performance of emerging public companies focused on providing cloud software). On the other hand, this week also showed the market’s optimism in a sustained recovery from Covid-19. American Airline stock rose 41% on Thursday – setting a three month high – on news that the airline expects capacity to rise in July to 55% of where it was the prior year and the average load factor had improved week over week. Although the stock is still down 42% for the year, Thursday’s news may be a harbinger of what’s to come for other cyclical stocks that were beaten down during the pandemic.
Markets may seem puzzling to institutional investors in it for the long term, but we think several trends have been in the making for the last 10+ years that are factoring into market moves today. The share of passive continues to be high. Bloomberg data indicate that almost 60% of equity assets globally, and about 50% in the US, are managed passively. Another trend is the growing share of retail investors, which recent data show now account for approximately 43% of the US equity market share. Mutual funds account for a similar amount, and hedge funds for 15%. So while institutional investors are focused on what hedge funds and other active investors are doing, the market continues to get pumped up by retail investors buying.
In fact, the last few months seem to have been a home run for retail brokerage firms. In quarterly earnings results, Charles Schwab reported that their clients opened a record 609,000 new brokerage accounts in the first quarter with over 280,000 in March alone and are setting multiple single-day records for trading. This resulted in 27 of the 30 highest volume days in the history of Charles Schwab. TD Ameritrade, E Trade Financial, Interactive Brokers and Robinhood all reported similar trends.
In another sign of our investment themes at the intersection of technology and finance – Robinhood saw record deposits in Q1 with daily trades up 300% and said their app continues to take 50% of market share for new brokerage sign ups – over half their customers are first time investors.
How to guard against dangers ahead. Where retail investors see an opportunity, many institutional investors see growing risks. Managing with a growing probability of greater downside than upside in the markets is one reason for institutional investors to pause and think about how to protect these risks. RockCreek is working on one line of research that combines realized volatility and implied volatility to produce a mixed volatility instrument, providing protection without the usual costs associated with hedging from solely implied volatility. Some consider reducing equity exposure and increasing cash as a hedge - though given the impact on returns and market timing, cash is not always ideal.
Another common hedging technique is diversification – the only true free lunch. This has served investors well in the past but less so in recent years given low yields from fixed income. Gold has been considered by many investors in the past few months. Gold has a negative correlation with real interest rates, and as a result does well when real interest rates turn negative. During periods of equity stress as we saw, central banks adopt an easy monetary policy that can result in negative real returns from fixed income. However, on an ongoing basis it may be difficult to use gold as a diversifier due to issues of availability and ease of investing – much of the same issues that crypto currencies exhibit. Protecting portfolios using put options is simplest to execute but comes with a whole host of disadvantages well known to institutional investors that have experimented with it in the past. Put option protection can be expensive, require market timing, and sophisticated implementation. The development of the VIX index and the associated futures trading has improved the trading environment for implied volatility. However, the VIX index is not fully transparent and is subject to concerns of market manipulation. Nevertheless, it is a liquid instrument that can be used by investors seeking to market time their hedges and thereby reduce the overall costs of hedging.
We continue to look at ways to hedge knowing that “the only perfect hedge is in a Japanese hedge.” As we manage through these uncertain times and prepare for potential risks to the downside, we are also reminded that patience, flexibility, and diversification are always winners in the long term game of investing.
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