Roller Coaster Ride

So much for a return to normalcy. This year has been anything but, despite the best efforts of a new US Administration to project quiet calm and effectiveness in the face of urgent domestic and global challenges. First, last week showed that the pandemic that upended life in 2020 is not going to go away quietly. A race is now on — between more infectious and maybe more dangerous mutant variants of the disease and the vaccines needed to combat Covid-19. The post-Covid-19 economy may become the “learning to live with Covid-19” economy. As if that wasn’t enough for investors to digest, an explosion of anger — and enthusiasm — on the internet helped an army of small investors roil the world’s deepest financial markets, and send large hedge funds running for cover. Regulators, politicians and others called for something to change. But what? And to benefit — or protect — whom?
Let’s start with GameStop, before turning to new forecasts for the real economy, Covid-19 and the vaccines and, lest we forget, climate change — still the world’s biggest challenge.
Observations and takeaways for investors:
1. Was GameStop a fluke or are financial markets forever changed?

What happened in markets last week will almost certainly lead regulators to do something. What that will or should be is less clear. 

The populist-tinged frenzy over GameStop and other heavily shorted stocks created a short squeeze the likes of which we have not seen for a long time. It may seem easy to agree that small, retail investors should be protected from taking undue risks in today’s complex financial markets. Sophisticated financial players are presumed to have an advantage. But in this case, smaller investors trading these stocks seemed to have got the better of the professionals — at least so far. Complicating the issue for financial regulators is that political disaffection and the internet are a key part of the story. Retail investors, chatting to each other on the internet and trading on Robinhood and other new platforms, turned what started as a clever trade into an extraordinary crusade against Wall Street in general, and hedge funds in particular. In the process, many small investors were enriched beyond their dreams, at least on paper, while major hedge funds had losses in the billions. Surely, the financial system will not quite be the same again. The boom in these stocks will likely end, no doubt hurting many small investors, as politicians fear. But this may only exacerbate anger at a financial system that seems to advantage the big and better-financed players, and increase calls for change. Meanwhile, we are continuing to see the power of the internet to drive action and protest. 

In this case, internet chat rooms helped a crowd-sourced short squeeze, using options as well as cash markets, to accelerate at extraordinary speed. It didn’t seem to matter that stock selection was driven by nostalgia as much as market savvy. GameStop video stores and cinema chain AMC both symbolize a past life, although AMC may live for another day as the enormous rally in its stock price enabled it to issue stock and pay down debt. As internet groups hailed the initial success of the trade and anointed heroes such as “Roaring Kitty” — in real life a Massachusetts financial adviser — for beating Wall Street financiers at their own game, millions of others joined in. A temporary halt, when Robinhood stopped accepting buy orders for selected stocks to stem its own bleeding, led to outrage on the internet, and among politicians from Rep. Alexandria Ocasio-Cortez on the left to Senator Ted Cruz on the right. Their question: why should wealthy investors and financial firms using traditional brokerage firms be allowed to trade while small investors were stopped? 

Gary Gensler, President Biden’s nominee to head the SEC, is no slouch. He was a sophisticated financial market player before he turned regulator, first at the Clinton Treasury and then as Obama’s reforming Chair of the CFTC. Most recently, Mr. Gensler has been teaching and doing research into finance and fintech at MIT, focused on making the financial system safer and more inclusive. He will be expected to come to his confirmation hearings — not scheduled as yet — ready to take on inequity, and address financial and market inclusion.

Based on prime brokerage data, Wednesday was the worst alpha day on record for hedge funds and also the biggest deleveraging.
The sheer volatility of GameStop’s stock has been breathtaking. On January 4, it traded at $17.25 but 10 days later it was up to $39.91. By the end of Tuesday, the stock had closed at $147, on Wednesday at $347, and it reached a high of $483 on Thursday — a whopping 2,700 percent return! A confluence of factors contributed to the GameStop trade spreading like wildfire. Scrolling through WallStreetBets, it does not take long to recognize a fierce us-versus-them mentality and a strong sense of loyalty among the community. For many, the opportunity to “stick it to the millionaires and billionaires” was as enticing than the allure of easy profits. Perhaps this should not be all too surprising among Millennials and Gen-Zers whose attitudes towards capital markets were influenced by the damage done from the Great Financial Crisis. With the help of trading platforms like Robinhood that have made it much easier and to invest in options, the WallStreetBets community, along with many others, were able to greatly amplify their influence. Indeed, we saw a tremendous spike in demand for short-dated call options.

While a handful of hedge funds, most notably Melvin Capital, were caught up directly in GameStop, most were only marginally affected or suffered mainly from collateral damage as prime brokers cut back on lines of credit and requested hedge funds start to deleverage because of the heightened volatility. Regardless, most hedge funds were unwinding positions in other heavily shorted stocks not knowing what the next target might be. Speculators were actively seeking to replicate GameStop-like profits in other beaten down names like AMC Entertainment, GSX Techedu and Blackberry, among others.

It’s likely most hedge fund managers who were short GameStop have capitulated in order to protect capital and live to fight another day. If it becomes obvious to the retail crowd there is no longer an inviting target on the other side of the trade, an end to the GameStop madness may come sooner and more swiftly than many expect. Sadly, WallStreetBets has no shortage of testimonials from young and low-income people who have bet their entire savings on a single volatile and entirely overpriced stock.

Clearly, some hedge funds suffered large losses last week, but despite all of the negative headlines, most funds were not so severely impacted and Thursday saw short-sellers claw back some of the previous day’s losses. There was some spillover effect into Europe and Asia due to broad deleveraging, but nothing close to the volatility we saw in the US. The expectation is that this current bout of volatility will last a little while longer, but we’re already seeing both hedge funds and traditional investors positioning themselves to take advantage of dislocations that have arisen from this current episode.

2. Normal recovery will resume — but not yet

Just as economists have been upgrading forecasts for global recovery, the virus that caused the recession in the first place has become more dangerous. 

After the sharpest fall in global output since the Great Depression, the world economy is poised to rebound — with global growth of 5.5 percent now forecast by the IMF, up from 5.2 percent just three months ago. That was before the announcement of safe and effective vaccines. But, as the IMF pointed out in three new papers last week, the speed and success of the fight against the virus remains a key risk to the outlook for global growth, financial stability and fiscal policy

In the US, the recovery is stuck in neutral. New layoffs in America are still higher than at any time during the global financial crisis; consumer spending was likely down in December, despite the holiday; and other real-time indicators, from the Fed’s weekly index of activity to travel and restaurant data, have all slipped or dipped in the last few weeks. Reflation trades ended up — just — in January, but investors need to continue to factor in the impact of Covid-19 on different sectors and companies, perhaps for longer than expected. 

 
The good news is that actions taken by central banks and governments have succeeded in cushioning the blow from the pandemic, for many Americans. And policymakers are planning to keep on doing what they’ve been doing. Fed Chair Jerome Powell clarified that last week, when he also warned about the new virus variants. He is not afraid of the inflation that some analysts have warned is coming. After a roaring start to the year, recent equity volatility highlights the fragile nature of markets, but we remain cautiously optimistic about the near term. A wave of liquidity from central banks, a continued vaccine rollout and fiscal stimulus hopes continue to be a tailwind for investors. For investors, staying cheerful will mean looking through the next few months, and relying on low interest rates and ample liquidity to continue to buoy financial markets. 

A defining feature of this recession has been its lopsided impact on individuals, businesses and countries, hitting hardest those who are most vulnerable while leaving others almost unscathed, at least financially. Just as Americans, overall, have improved their financial position in this strange recession so the number of businesses forced into bankruptcy has been unusually low. We have commented before that the window for successful trades in distressed assets closed almost before it opened. The data for bankruptcies shines a light on this.
President Biden has made clear that improving the lot of those at the bottom of the income scale is as important for him as getting better overall numbers for growth and employment. He will fight hard for the ambitious $1.9 trillion budget package that he has laid out. But he also wants to show unity. How far will the Administration compromise to get a bipartisan bill? Indications are that many Republicans in the Senate — and maybe conservative Democrat Joe Manchin — would like to reduce the new $1,400 proposed stimulus checks, cut the funds for states and local governments and focus on spending for Covid-19 relief and vaccine distribution. That would likely also mean abandoning the $15 federal minimum wage. Even if many in both parties support raising incomes for low-wage workers, especially those on the front lines during the pandemic, it is argued that this bill is not the best place for such legislation. Neither the president nor Democrats in Congress are ready to give much ground. Yes — they are open to negotiation, they say. But no — they will not compromise on having a package that is both comprehensive and speedy. Meanwhile, President Biden is planning to sit down with 10 Republican Senators who wrote to him this weekend asking for serious discussions, if unity is desired. Their opening bid is far below $1.9 trillion. Mid-March is the likely real deadline, when the latest boost to unemployment benefits is set to expire.

The power of the president’s bully pulpit this year and next will depend importantly on success in turning the corner on the pandemic. The Administration’s first 10 days in office showed just how hard that will be, globally. “The whole world is connected,” said RockCreek Founder and CEO Afsaneh Beschloss in the latest issue of IFC Insights. “The number one issue with COVID now is there needs to be much faster and more equitable distribution of the vaccine. There will be a greater push to help lower-income and fragile economies to acquire and distribute vaccines more equitably,” said Ms. Beschloss. To end the pandemic, there needs to be cooperation between scientists, governments, the private sector, and multilateral organizations to ensure no place is left behind. Read the full article here

As pharma companies and governments struggle to produce and distribute vaccines fast enough, tempers have frayed. In Europe, regulators are disagreeing about the efficacy of some of the vaccines coming on stream. German health officials said that they will not distribute the AstraZeneca/Oxford vaccine to over 65s as the data is too limited to demonstrate that it works. But the UK disagrees, and so it seems does the European-wide regulator which on Friday finally approved the vaccine for emergency use. Confusingly, Europe is also fighting with the company — and tangentially with the UK — over supplies. Contract disputes have spilled into the public and an ugly spat between the EU and the UK over vaccine supplies dominated headlines across the Atlantic. EU Commission President Ursula van der Leyen backed down after a tense phone call with UK Prime Minister Boris Johnson. We need vaccine cooperation, not vaccine war — and as a former sherpa, I have seen the power of US leadership to bring other governments together. We need that now. Many in Europe are frustrated by the EU’s slow vaccine rollout. With only 2 percent of the population vaccinated, Europe risks a longer lockdown and slower recovery. By contrast, the UK has now vaccinated 13 percent of its population. In the US, despite all the hiccups, the number is over 7 percent. Together with the US fiscal boost already in the pipeline and more to come, that makes the IMF believe the US economy will be back on a pre-Covid-19 track long before Europe.

Markets agree. US markets continue to outperform Europe, although last week saw US stocks down, in the worst week since October. Amid all of the headlines about vaccines and variants, and market action in previously deadbeat stocks, it was easy to lose sight last week of the fourth quarter corporate earnings reported, including Apple’s beat and astonishing revenue milestone of $111.4 billion. So far this year, 30 percent of companies have reported in the US, 10 percent in Europe and 17 percent in Japan. Initial results point to strong earnings, especially across technology, financials and basic materials related names. But markets have not rewarded the strong performance. Indeed, some companies that beat expectations — notably Apple, Tesla and Facebook — were outright penalized relative to the broader market. Perhaps a sign that investors are looking more to the future as forward guidance metrics looked relatively soft in company announcements. This should not come as a surprise: estimates were significantly revised upwards in the third quarter perhaps pulling future earnings forward. Careful selection is important for investors: the data point to a relatively healthy growth environment for global companies, with the market starting to differentiate across countries, regions and sectors.

Emerging markets continue to look to be the longer-term growth engine relative to developed markets. Investors are starting to act. Foreign flows into emerging markets received the highest weekly inflows in history at the end of January (+$7.9 billion, from +$5.6 billion the previous week). While the strong inflows were not enough to offset overall negative equity performance in China, Taiwan and Korea, we believe the trend of investor interest will continue. Spillover effects from US market volatility and local investors raising liquidity ahead of the Chinese New Year holiday were the primary drivers of the negative price action in China last week — not a loss of investor confidence. With little change to the risk backdrop for emerging market assets so far, the US 10-year real yields back to within 5 bps of the all-time lows and strong economic activity data in select EM countries, there are few headwinds for EM investors. The opportunity set in Asian market — including China, Korea, Taiwan and Japan, all economies highly levered to the global recovery — continues to be attractive. 

Last week highlighted that whether it is complex market dynamics, unexpected earnings, geopolitical news or a myriad of other potential surprises, investors should continue to brace for spurts of volatility.

3. Taking the climate challenge seriously?

Without the US, there was no chance that the world could address climate change successfully. We will get a sense in coming months of whether progress is possible now that the US Administration is committed to action. Much will depend on public-private cooperation — to build new green infrastructure; to transform the energy sector; to promote finance for energy efficiency whether in buildings, transport or farming; and to fund basic research into technologies not just to reduce the cost and expand supply of renewables but to discover ways to reduce carbon already in the atmosphere. Already “brown” companies like Exxon are spending on carbon capture and changing their investment mix to cleaner energy, while retail and institutional investors are asking more questions about the climate impact of companies they invest in. 

President Biden said that he will focus on jobs and opportunity when addressing climate change. For investors, the renewed focus on climate also offers opportunities. Investments in renewable energy, energy efficiency, storage, waste/water and other related areas are at the forefront of many investors’ minds with the tailwind of the Administration’s support. 

The transition to net zero emissions, now being promised by more major countries, could provide one of the biggest investment opportunities of the next 20 years. Climate investments in a portfolio will be increasingly common. Accessing climate investments globally will be equally critical. The IFC estimated $23 trillion of climate investment opportunities in emerging markets alone between 2016 and 2030. One can take many approaches to investing in climate. Opportunities are multifold and range from buying large public companies that have committed to reducing and eliminating carbon emissions to investing in private companies focused on battery storage solutions, solar, wind, hydrogen, and services supporting renewable energy, energy efficiency, and waste and water as just a few examples.
RockCreek Update
Last week, RockCreek released our Q4 2020 commentary letter. If you missed it, read the full note here

The RockCreek book club met this week to discuss Marcus Aurelius’ Meditations. To celebrate Black History Month, our next read will be the Pulitzer Prize-winning novel The Underground Railroad by Colson Whitehead.


Team RockCreek

Share on facebook
Share on twitter
Share on linkedin
Share on email
Share on print