Smart Money

Our regular summary of the capital markets. Check back each month for new updates.

Smart Money

March 31, 2020

Taking Care of Business

Smart Money

The emergence of COVID-19 has changed our lives in multiple ways. As we navigate through the crisis, we are working differently but still helping our clients understand the financial implications of the disruption and encouraging our players to stay productive during the shutdown. We hope this video helps you stay informed and entertained.

Taking Care of Business During the Shutdown

March 26, 2020

Just when you thought it was safe to go back in the water

Market Recap & Box Score

Despite providing our last market update just ten days ago, we wanted to offer a recap of the events as governments have implemented measures to protect the economy and maintain order in the financial markets. Here is the good news … on 25-Mar-20 the US announced a $2.2 trillion fiscal stimulus package, helping citizens through direct payments and unemployment benefits, while also sup...

Despite providing our last market update just ten days ago, we wanted to offer a recap of the events as governments have implemented measures to protect the economy and maintain order in the financial markets.

Here is the good news … on 25-Mar-20 the US announced a $2.2 trillion fiscal stimulus package, helping citizens through direct payments and unemployment benefits, while also supporting small and large businesses through access to credit.  These measures were delivered after the Fed cut rates to zero and announced a $700 billion quantitative easing program.  To help ease corporate funding, the Fed restarted its commercial paper funding facility, indirectly purchasing short-term obligations to lower funding costs.  In addition, the Fed announced a plan to increase Treasury purchases, and more importantly, expand their planned products to corporate bonds and the ETFs that hold investment grade issues.  So far it seems that the market has appreciated the efforts.

From its bottom on 23-Mar-20, the S&P 500 has appreciated 20%.  Accordingly, March 2020 has produced both a bear market and bull market! The TSX rose 19.5% from its low.  Despite this strength, the S&P 500 and TSX are down 19.3% and 21.6% year-to-date.

Rates have been equally entertaining. The 10-year US Treasury Yield fell from 1.91% on 31-Dec-19 to 0.50% on 09-Mar-20.    The sinking long-dated rate reflects the slowing economy.  The significance of the deceleration is amplified when one considers that the yield was 3.20% in November 2018.  At the time of writing this brief, the yield rebounded to 0.74%.

The flow of investment capital has been a significant contributor to the market volatility.  Many large players like relative value strategies, hedge funds, and commodity trading advisors (CTAs) reduced their exorbitant leverage and/or moved from a net long to a net short bias.  This indiscriminate selling to lower their exposure and leverage impacted the benchmarks to the downside. It seemed like most of this forced selling was complete late last week.  But then another large player entered the mix.  The end of March is rebalancing season for pension plans.  US pensions maintain an equity bias due to their overly aggressive 7%+ return targets.  This means that after a 25-30% selloff in equities, they must purchase more stocks to bring that content back to a prescribed level.  Accordingly, pensions need to sell Treasury Bonds to finance the stock purchases.  Goldman Sachs estimates that this quarter will be the largest dollar value of pension assets moving into equities on record (second to Dec-18), requiring $280 billion of purchases during the final week of the month.

Covid-19 is still in its relative infancy in North America.  Trump’s “Back-to-Work-by-Easter” pledge may put some at ease as it relates to the short-term economic impact of the virus. However, we fear that the human and healthcare toll will be dreadful if this promise is fulfilled.  It still does not seem that the US population is taking the threat seriously, especially given the country’s high incidence of diabetes, obesity and hypertension, relative to the Asian nations that were originally exposed to the virus.  In addition, the US just reported that an astonishing 3,300,000 workers filed for unemployment last week, a number that was more than twice as high as consensus estimates.  If Covid-19 infections accelerate exponentially, unemployment will swell, consumer spending will grind, and business activity will stall further.  A potential corporate default cycle could ensue which would render the prospect of a V-shaped recovery a fantasy.

There are two primary factors that have influence over our willingness to increase growth assets materially in our portfolios: a sustained recovery in credit and a fall in volatility.

Often credit leads the way in a recovery.  In the embedded chart, yields (represented by the black line) begin to fall late in 2008, a full four months before equities.  The S&P bottomed after a further 24% slide.  Currently high yield spreads, as measured by ICE BofAML US High Yield, are 10.11%, up 6.45% from the February low.  This level has not been seen since June 2009.

Volatility, as measured by VIX, remains above 60, which implies that there is no end in sight for these large market swings.  Humans are loss-minimizing creatures by nature, meaning the pain experienced by a loss far-exceeds that of a gain. Therefore, a continuation of high volatility suggests that uninterrupted equity market gains are not imminent.  We would prefer to see both yields and volatility come down in a sustained manner before believing the three-day rebound is anything more than a bear market rally which are prevalent across almost all historical selloffs.

March 16, 2020

Frightened Investors Trigger Sell Off Due to Coronavirus Pandemic

Market Recap & Box Score

In less than one month, the S&P 500 gave back almost the entire 43.7% return it achieved since the low on Christmas Eve 2018; and, it revisited levels not seen since Feb-17.  Since our last update on 20-Feb-20, the S&P 500, TSX, and MSCI Indices are down 29.3%, 31.1% and 29.8% (as at 16-Mar-20). While the sheer degree of the pullback is newsworthy, the volatility and velocity ...

In less than one month, the S&P 500 gave back almost the entire 43.7% return it achieved since the low on Christmas Eve 2018; and, it revisited levels not seen since Feb-17.  Since our last update on 20-Feb-20, the S&P 500, TSX, and MSCI Indices are down 29.3%, 31.1% and 29.8% (as at 16-Mar-20).

While the sheer degree of the pullback is newsworthy, the volatility and velocity of the move is really astounding.  In fact, the 12% drop on 16-Mar-20 marked the first time since the Great Depression that investors have seen either 6 consecutive days of 4%+ moves, or 3 consecutive days of 9%+ moves in the S&P 500.  The blowout in volatility has not been confined to equity markets either, as it has crept into gold and oil, among others.  Speaking of oil, it has experienced its own fair share of problems in March.  Russia refused to comply with a planned production cut to help alleviate the demand disruption caused by Covid-19.  In response, Saudi Arabia showed once again who truly runs the table at OPEC, announcing they would increase supply to record volumes, over 12MM barrels per day, beginning in April.  With this and planned increases from Russia, UAE, Iraq and Nigeria, the supply glut has pushed the price of WTI down 45.2%.  This will surely add strain to an already weak US Shale sector, further adding stress to weak corporate balance sheets.

In 2019, many investors became increasingly convinced that stock markets only move in the “up” direction.  They found themselves chasing a market that was running away like it stole something.  Today, these same investors are complaining that the pullback, spurred by Covid-19, is a Black Swan that nobody could have foreseen.  While foreseeing a global pandemic is difficult, Coronavirus has been newsworthy since December and it was highlighted in our newsletters since January. Irrespective of the predictability of the virus’s impact on capital markets, the economic slowdown was evident before the respiratory illness was distinguished from a Sunday morning reaction to a Corona overindulgence.

It was plainly obvious that leverage in the corporate system was becoming a potential red herring.  A rising stock market was diverting cash flows to stock buybacks rather than strengthening the balance sheet, optimizing the supply chain, or investing in PP&E.  Further, the popularity of just-in-time inventory management to better streamline working capital caused corporations to become more fragile to any interruption in sourcing and maintaining adequate inventory.  Does this mean that these aforementioned points were enough to spur a 30% equity rout? No, but it indicates that corporations and the global economy were uniquely sensitive to anything that could disturb the status quo.  Introduce a novel virus … which is uniquely contagious in its underlying ability to be spread by asymptomatic or mildly infected persons, but severe enough to hospitalize between 10-20% of the afflicted… and, you have a perfect storm for the healthcare system, credit markets, the economy, and small and medium businesses and their owners/employees.

Is this to suggest that GAVIN anticipated where the puck was going and was short equities/long duration beginning on 20-Feb-20?  We wish!  However, we have been managing our clients’ assets with prominence for downside protection.  Considering the economic factors discussed above, we maintained exposure to ‘risk assets’ (ie. individual stocks and long-only funds) to approximately 40-50% depending on our long-term investors’ risk tolerance.  Moreover, we were consistently increasing exposure to Alternative Assets, excluding private equity, as economic perils mounted.  In addition, we know each clients’ cash needs for any given 6-month period and ensure that there is always adequate liquidity in the form of cash or short-term instruments to cover these obligations.  This has allowed us to minimize our downside participation in chaotic times; and, equally important, we can monetize and reallocate to risk assets when we feel the discounts are sufficient to allow for a proper margin of safety.  This does not imply that we will time the bottom, far from it, but we have the flexibility to average into positions in great companies that we are comfortable holding through and post Covid-19.

It was difficult to field questions in 2019 about the absence of 30%+ returns in our client portfolios.  Further, our apprehension with valuations and the sustainability of the bull market caused us to miss out on new clients who were reluctant to part with their 100% equity allocation.  However, we are in the business of preserving wealth; as such, during turbulence we can demonstrate the benefit of investing through a full market and the value of active management.  It is now on us to continue to stay vigilant, and to effectively transition from the defensive zone through the neutral zone and into the offensive zone.