In a well-known Scottish joke, a visitor to a village stops and asks a resident how to get to a large city.
The resident looks up and says, “Oh, if I were going there I certainly wouldn’t start from here.”
This simple joke illustrates the complexity that faces many institutional and individual investors as soon as they emerge from the current “fog of war” in which they are managing their investments through the fastest stock market correction in history.
It encompasses the trifecta of the initial conditions, the journey and the destination, all of which influence the extent to which the coronavirus-driven financial disruptions will spill over into the broader economy.
Markets entered the coronavirus shock conditioned by many years of ample and predictable liquidity injections by central banks. The resulting repression of volatility, and the seemingly endless decoupling of elevated asset prices from more sluggish fundamentals, encouraged ever more risk-taking.
Investors relied on what is known as the central bank put, or comfort that central banks will always be willing and able to provide an effective backstop for their investments. With that came increasing complacency toward what investment professionals refer to as the equity, credit and liquidity risk factors. (That is, the risk of sharp deteriorations in companies’ earnings and profits, of a spike in corporate and sovereign defaults, and of an inability to reposition holdings).
The result was an investor base that took on too much risk, a growing component of which resided in asset classes well beyond their natural habitat and lacking inherent liquidity.
The complacency was not limited to investors, who are the demand side for investment products. Suppliers also became infected, first meeting the demand through simplified and seemingly more flexible liquid vehicles, the prime example being the proliferation of ETFs both overall and in segments of the main stock and bond markets.
This then migrated to less liquid asset classes, including inherently illiquid segments such as corporate bonds in emerging markets. As I’ve been warning for several years now, all this risked leaving the investment world particularly vulnerable to a bad exogenous shock, let alone a devastating one such as the coronavirus shock.
Central bank crutches won’t help
By rendering both monetary and fiscal stimulus ineffective for now, and by unleashing an unprecedented period of unsettling uncertainty and fear, the coronavirus has simultaneously destroyed supply and demand and has plunged the global economy into a deep recession, if not worse. This constitutes a fundamental reversal of the prevailing market paradigm that is also having to cope with the sudden disappearance of the central bank put.
It is an environment in which most investors’ assessment of equity and credit risk goes from a flashing green to a constant red. The resulting desire to reposition badly offside portfolios is frustrated by a lack of liquidity that reflects more than just its under-appreciation in the run-up to the shock.
The industry itself is structurally less able and willing to provide it given that its capacity to absorb risk has been sharply curtailed by regulation post the 2008 global financial crisis, consolidation and tighter risk management.
The result of all this is already clear from what has transpired in the last few weeks, from unsettling market volatility and a sharp plunge in asset prices to a breakdown in traditional risk mitigation tools as some investors look to dispose of whatever they can in their scramble into cash. This explains days of simultaneous declines in the prices of both risky assets, such as stocks, and traditional risk-free safe havens, such as government bonds and gold.
The more this continues, the higher the vulnerability to financial market failures and the greater the risk for yet another big blow to a real economy already reeling from the twin collapse in consumption and production.
Huge central bank intervention can — and should — minimise the risk of market failures. But it will struggle to place a net under markets off of which asset prices could bounce sustainably absent investors feeling more confident about health-care solutions to contain the spread of the virus, treat illnesses and increase immunity.
This is the tough journey that investors face. I would argue it’s uniquely complex, and that’s before factoring in the wrong starting point and an asset-management industry being hit by the nightmare trifecta of investor redemptions, falling asset values and negative relative performance for many active managers. Then there’s a host of uncertainties about the destination, an additional complication that is yet to be internalised by most analysts and investors.
While much will depend on the severity and duration of the coronavirus shock, there’s already evidence of potential changes to the post-crisis landscape — something that I am spending more time analysing. And, returning to the risk factor characterisation, they will impact interest rate risk as well as equity, credit and liquidity.
It is already clear that markets will be navigating through a huge increase in fiscal deficits and central bank balance-sheets; large-scale corporate bailouts and the tricky political decisions that come with them about which sectors and companies to help and how to allocate support among people and different suppliers of capital (including within layers of the capital structure); omnibus legislation on payment holidays; and a big corporate rethinking of the cost-benefit analysis of globalised supply and demand chains.
These are only four items on my list of uncertainties about the post-virus economic and financial landscape, and it’s a list that is bound to grow the longer the economic sudden stops continue. It is a reality that investors will have to deal with, regardless of where they start out.