In the midst of surging fears of coronavirus, there have been extreme moves in the markets for several weeks:
- Volume: Trading volumes in all asset classes spiked when the sell-off began and peaked around 27-28 Feb. Since then, even though markets have moved lower, this has been on much lower volumes, implying a lot of asset managers are staying away from markets waiting for more clarity on government responses from major economies and assessing the economic impact of the spread of the virus. When there are fewer market participants, prices tend to swing a lot more, as there will be an imbalance between buyers and sellers. For this reason, whilst uncertainty prevails, heightened volatility with extreme market moves is expected to continue. (Copia’s periodic rebalancing approach means we purposely avoid over-trading, and only invest in liquid instruments where primary or secondary volume is ample relative to our size.)
- Margin calls: Some investors/traders/speculators trade using a Margin account. These margin traders need to put down only a small fraction of the total value of their investment position. Trading on margin creates implicit leverage that can amplify both profits and losses. Given the unexpected sharp drop in stock prices, margin traders are more susceptible to Margin Calls when they are required to post additional funds to offset a loss in value of their position. There are signs recently that some people are facing margin calls, forcing some people to close their positions by selling at depressed levels, or requiring them to put down more cash – raised by selling other positions that have held up in value like bonds and gold. (Copia does not trade on margin – it is highly speculative).
- Leverage: whilst lending has been cheap, some investors have borrowed money secured against their investment portfolio to invest in the markets, either to enhance returns or to change the risk-return profile of their investment strategy. Like a mortgage, these type of loans have a loan-to-value limit, and the collateral is not a house but a portfolio of investments. If investors have borrowed using a high loan to value, the lender might be asking for additional collateral or loan repayments to keep loan-to-value on target: this in turn can trigger selling pressure to avoid defaulting on those loans. (Copia does not use leverage).
- Gold: Gold has sold off sharply during the last few days, even though Gold is a safe haven asset class. One hypothesis for this is that some market participants who hold both gold and equities are facing margin calls, those traders are choosing to sell gold to raise cash and meet the margin for equities. (Copia owns physical gold funds within our Select range as a diversifier).
- Bond Yields: US treasury bonds are considered safe haven assets. US bond yields made a low on 9th March but even though we have seen equities drop below those level of 9th March, US treasury bond yields have moved higher. It indicates investors are not piling any more into safe haven US treasury. Investors are sitting on a hoard of cash. This is a positive sign for Equities picked up by the Risk Barometer. We do not hold US treasuries directly or indirectly for our GBP investors, but similar trends in the UK market and similar policy response from the Bank of England (cutting interest rates) has been supportive of the gilts exposure that we hold across portfolio in different proportions and for different terms.
- Credit Markets: The biggest risk for the markets is a cascade of Corporate Bond defaults due to a recession. Fed, ECB and other central banks are propping up corporate bond assets and we are not seeing credit spreads blow up like we saw in almost all of the past recessions. This is a positive sign for Equities picked up by the Risk Barometer.
It’s not 2008
Bottom line is the plunge in global markets owing to the Coronavirus is not a repeat of the financial crisis of 2008: both the economy and the financial system are in far better shape than then.
In 2008, policy makers (e.g. central banks) were having to make up how to respond to the systemic risks of 2008 as they went along. In 2020 they have the tools, contingency plans and playbook of when, how, and how much to respond to shocks like this. We expected prompt and decisive action, and it’s already happening.
Wave of chaos and “peak panic”
We see the virus as a 2-3 month gruesome “wave of chaos” impacting each market it infects in turn. But, with the right policy interventions, it’s impact is an “S-curve” (as we see in China and South Korea), after being a J-curve (as we see in Europe, and the US). Whilst Europe is the centre of the pandemic now, it’s worth noting that infection rates have tapered off in China, and are tapering off in South Korea.
So once this wave of chaos has passed through developed markets – the UK, the EU, the US, tragically creating a very human cost, the key question will be – is this the trigger for a sustained global recession, or a short-sharp V-shaped shock?
A global recession is what markets are now pricing in. It’s also what policy makers are responding to. It’s hard to see further out when you are in the eye of the storm.
So noise, volatility and fear will continue. We are not yet at “peak panic” in the UK or US – the army are not yet patrolling the streets as they did in China and are now in France and Italy. We don’t know when peak panic might be – but probably in the next 2-6 weeks when cases become overwhelming in the UK. But once we are past peak panic, and new cases are tapering off and we are on an S-curve, not a J-curve: how will we look at markets then? Will those depressed valuations look justified, or like a buying opportunity?
It is crucial for investors and indeed managers to avoid an emotional approach to investing and stick to their strategy during market turmoil. Our key messages are:
- Keep calm, and stay invested. Rebounds can kick off as violently as shocks kick in. Paper losses are only economic losses if crystallised.
- The shock to markets has been scary, but is in scope. We are tracking the market shock from a value at risk perspective. Whilst the virus shock has triggered a large and rapid sell off, this is not necessarily a repeat of 2008.
- At times like this, sticking to your investment process is key. This means relying on data, not emotions. We rely on the Risk Barometer to look through the noise to the numbers.
A disciplined and robust investment process makes sense at all times. Sticking to that process in good times and particularly in bad times is key. That mitigates behavioural errors that are triggered by emotions.
To recap on our process: we run periodic realignments, with a tactical asset allocation overlay set by our Risk Barometer that is designed to narrow the dispersion of returns for a given risk-return profile, rather than to “call” the markets. That means in the next realignment we will be buying risk assets to get them back to model weight.
Our Risk Barometer is an indicator not for next week’s market direction but for the medium-term economic outlook. Despite the turmoil, it is still in the green zone – reflecting the massive stimulatory impact of Fed, ECB and BoE interventions. Through the noise – to the numbers.
The Risk Barometer cannot predict unpredictable shocks. We do not expect it to. And the shock we’ve experienced is within the VaR (Value at Risk) estimates we had for the portfolios.
So we are staying calm and sticking to our process. We urge advisers to encourage their clients to keep calm and stay invested.
Our contingency plans were designed to:
- Enable and adapt business continuity to both the primary health risks and related second-order risks (e.g. lockdown) associated with Coronavirus
- Minimise risk of simultaneous incapacity of team members
- Use Business Continuity Plan protocols and controls to implement that contingency plan
What have we done so far from an operations perspective:
- We set a “trigger” threshold of UK cases to implement those contingency plans.
- We tested our contingency plans on Fri 6 Mar.
- We implemented those contingency plans on Mon 9 Mar, once UK cases crossed the 50 mark.
- The Copia team has been working on a (“distributed”) basis running all core functions remotely since that date and has been operating successfully with full access to all the data, systems, processes and controls we need to manage the portfolios, along with a range of communication channels and a “virtual meeting room”.
- We retain access to the Novia DRP site if needs be, but do not expect to require use of it
- These measures are in addition to the business continuity measures taken by Novia
If you or your clients have any queries relating to markets, portfolios or our response to the situation, please do contact us.