Pension regime change from coronavirus - Increases in funding deficits

The Milliman 100 pension funding index provides insight on the current state of funding, and it is not good. The index has been in deficit since the Financial Crisis and the percentage funded is at only 82.2% as of the end of February. During the last two recessions, the index was showing a surplus, so pensions were less prepared for this shock. There is little doubt that the funding deficit may show the largest monthly decline in the series and push the percentage funded to below 75%. Discount rates will continue to fall and the ability to get back to balance is unlikely even under rosy scenarios. 

Similar increases in risk can be seen in the NISA Investment Advisors PSRX index. We will note that the funding deficit for their index fell by 25% between August and the end of the year 2008. 

The only way these gaps can be closed without digging into revenue (cash flows) is through improving the rate of return for the portfolio going forward. Unfortunately, the combination of a low yield and high volatility environment makes for thinking through the same asset allocation framework challenging. 

While it is still not employed by all pensions using an approach that thinks beyond traditional asset classes may offer promise. Thinking within a risk premia framework that include style premia may be offer return advantage by using a different weighing scheme. There is no perfect solution, but a change in regime also requires a change in investment thinking.

Contango, oversupply and commodity markets

The slope of the oil curve (contango) is the steepest since the Financial Crisis. Front month futures have fallen $40 per barrel this year. The current spread could further decline by up to 5 dollars a barrel to match Financial Crisis levels. Oil prices are at lowest levels since the 1990's. The demand shock with continued production makes for a logistical inventory nightmare that has not yet truly shown in EIA domestic inventory numbers which are similar to 2019.

This market is in a major imbalance that is not likely to be solved anytime soon given further social distancing. Of course, this is not the only market that is in contango. 

This is a bad situation for any investor that is long and has to ride down the futures curve, but it is a great opportunity for those investors looking for a liquid investment opportunity. Contango exists for most commodities with the steepest slopes in the energy complex. The only exceptions are in wheat, rice, and cattle. This is not a liquidity or relative value dislocation trade, but an opportunity to profit from the global demand shock.

Think about the economics of networks - Interconnectedness impacts any financial crisis

One of the significant research advancements since the Financial Crisis has been the development of network economics to help understand the propagation and amplification of economic shocks. Economics of networks deal with the linkages across economics agents that make up a market. Agents have different interaction functions or linkages which when blended together or aggregated form a network. Call this the connectivity of markets.

Researchers and policymakers are still trying to determine how to best use networks to understand the transmission of crisis and solve problems; however, it is important for investors to just think through the dynamics of networks in financial markets.  

In a past world, this industry analysis would be called market structure, but economics have moved well beyond the descriptive focus of structural analysis. When economic agents are more connected, their micro activities will spill over to other markets and players. Connectedness means that micro shocks can have greater systematic risks. A simple analysis of debt connections during the Financial Crisis can be seen using network technology. 

There is connectedness inside the firm, but the focus of network economics is how shocks can ignite or propagate across a whole economic system. Networks drive correlations. Correlations across markets are driven to one not just because there may be a common factor that is changing expectations but also because the activities of some market participants will lead to further reaction by others. A negative equity shock may lead to a margin call which requires a sale of unrelated assets. A failure of one firm may require higher collateral or lending terms for other firms. A bank cutting credit for a set of clients can lead to a cut in production in the real economic. A dollar move can impact bank lending and cause a credit shortage available for cross-border arbitrage. A bank reserve constraint for a money center bank can reduce the funds for repo lending and impact Treasury market liquidity. 

As policymakers have become more aware and sensitive to networks, there has been an increased focus on central clearing, the interactions of participants in over the counter markets, and measured the importance of large meaningful financial institutions. During the financial crisis, we learned that the failure of one institution cannot be viewed in isolation because its failure will transmit a shock to all economics agents it touched. Absolute size matters, and who you trade with matters. The contagion from any shock will move faster and deeper through financial markets when there is more connectedness.  

An investor does not need to know all of math behind networks, but there are some clear take-aways.

• Think beyond the immediate shock and focus on the second order thinking about connections.
• Connections and networks are everywhere but dynamic. The connections of economic agents matter even in a competitive market.
• More complex the market will be more impacted by network effects.  
• Follow the money - where it comes from and where it is going.

Market-making and arbitrage - A necessity not a luxury for the financial system

Corporations are taking down all of their credit revolvers. Money is being extended to consumers through credit cards, and consumer loans. Loan syndication is going to be on hold given many traditional buyers are pulling out, so loans are going to stay on the balance sheet of the originating bank. Banks are also holding off new commercial loans until some of the uncertainty is resolved and tightening credit through higher spreads. The Fed may have lowered rates, but that is not the same as increased lending. In some cases, deposit withdrawals are reducing the funds available for expanding the loan portfolio. This restructuring of bank portfolios along with regulations to maintain liquidity are constraining bank choices. This part of the financial system should be more closely followed

At the same time, there is greater demand from large money center banks for market-making, arbitrage activities, and the warehousing of risk. Yet, these banking activities are often considered luxuries relative to core lending. While profitable, these activities are often higher volume lower margin businesses. Additionally, given the Volcker rule and use of VaR type risk management, less capital can be committed to these business activities. 

There is an internal bank battle for where capital should flow, the real or financial economy. This is also a political battle because there is a view that banks should prioritize the real economy over the financial sector. Yet, a poorly functioning financial market system will spill over to the real economy. The ability to buy and sell at fair prices in capital markets is critical for money to continue to fuel the real economy. The US financial system is more capital market than bank lending focused. The disruption of capital markets will force financial intermediation activities on banks that they are not prepared for. 

Investors should appreciate that the Fed is serving as a market maker, arbitrageur (at least buying cheap), and warehouser of risk through the current alphabet lending and buying programs. Buying Treasuries should reduce the off the run illiquidity and reduce Treasury basis dislocations. Repo funding provides lending not available from reserve constrained banks Buying commercial paper, mortgages, and corporates will warehouse risk until we return to normal. The Fed is doing more than just supplying money. It the reliever of financial stress. 

Quick review of stresses by asset class and Fed response

All asset classes are suffering from a lack of liquidity, wider bid-ask spreads, and limited buyers even after we account for the last two days of gains. In some cases, dislocations have moved away from extremes, but generally all markets are still at elevated stress levels. There is little reason to believe that we have turned the liquidity corner. 

The coronavirus shock is just starting to hit cash flows for companies which means downgrades, defaults, and restructuring will spill over to the financial markets. The Fed has already provided unprecedented sums of repo financing and Treasury purchases are at a feverish pace, but also just getting started with their broader programs. Commercial paper and corporate (non-Treasury) buying has yet to ramp up albeit the markets has to a degree responded.  

While most investors are aware of stresses in the markets they usually trade, it is important to be aware of stresses in other asset classes. For example, dollar stresses that are trying to be relieved through dollar swaps between the Fed and other central banks may be one of the most important markets to watch for global stability. A liquidity government scorecard, (we have a more detailed scorecard for internal use), is necessary to gain a better overview of market dynamics.

Cash, near-cash, and new risky assets

Less than a month ago there were a lot of funds and short-term securities that would be considered close money substitutes. Of course, there are differences, but the pricing distinctions were minor. Those days are over. The range of what is considered near-money explodes when there is a crisis. Any perceived similarities are out the window. Money is not all alike, and investors, if they don't know already, should appreciate the differences. 

One of the roles of the central bank is to close dislocations between near-moneys because the impact of money dispersion on the real economy can be significant. The transfer of funds across broad money may not show up in statistics but will spill-over to lending. Now funds are growing through for all definitions of money, but there are winners and losers.

Money market prime funds have seen outflows of over $100 billion this month on a $700 billion base. Government money market funds have increased by $400 billion over the same period. The prime funds hold commercial paper while government funds do not. This change in flows is one of the reasons for the Fed's commercial paper program. 

Investor withdrawals from these funds forced the liquid assets ratio to dangerous levels. A fall below 30% would have allowed for restrictions on withdrawals which would have ended any illusions on whether these funds were near money. We are seeing banks buy assets from their money funds to ensure that they do not fall below the 30 percent weekly liquidity assets ratio. (See Goldman Sachs purchase of assets form Square Money Market Fund and Square Prime Obligations Fund, and BNY Mellon purchase of assets form their Dreyfus Cash Management fund.) 

The CME and other Financial Market Utilities (FMUs) are pulling money from their banks and placing funds at the Fed where they can receive the interest on excess reserves (IOER), a meager 10 bps. This drains bank reserves but gets the FMUs something closer to true safe cash, a better store of value than demand deposits. 

Investors are making strong distinctions between secured and unsecured overnight funds as measured by yield spreads. Clearly, if the demand for safe assets like Treasury bills is strong enough, yields can turn negative. These yield spreads and the pricing of money distinctions will close as we move away from the crisis, but right now, protecting liquidity and a store of value is paramount with many investors and they are not being irrational.  

The stress process - There are different stages of financial stress

In an effort to make sense of the current market shock, a crisis can be decomposed into a number of different market stresses. A shock will first cause a market stress and switch from risk-on to risk-off sentiment. If the shock is a large and common across more markets, there will be a movement to a correlation of one. As markets start to a correlation to one, there is a liquidity stress as markets become one-sided and bid-ask spreads widen. As the financial impact deepens, there is limits to arbitrage stress. Margins increase, collateral loses value and normal market linkages cannot be maintained. Financing becomes a problem for dealers and relative value firms.The expectational shock starts to be realized and there is a cash flow stress in the real economy. This will lead to credit rating downgrades. Finally, there is the problem of refinancing stress. Firms cannot roll their maturing debt or only borrow at much higher rates.

Central banks and government may use their powers to offset the different stresses. The response will be measured versus the stresses faced. As we move further down the stress spectrum, more support may be necessary to stop a cash flow or refinancing problem. Each Fed response can be mapped into the stress. For example, Treasury buying offsets one-sided trading. Repo funding serves to stop the limits of arbitrage and liquidity risk. The commercial paper facility helps with refinancing risk. 

‘We don't want nobody that nobody sent.’ - the new standard for trading relationships

“On the way home from law school one night in 1948, I stopped by the ward headquarters in the ward where I lived...I walked in and I said, ‘I'd like to volunteer to work for [Adlai] Stevenson and [Paul] Douglas.’ This quintessential Chicago ward committeeman took the cigar out of his mouth and glared at me and said, ‘Who sent you?’ I said, ‘Nobody sent me.’ He put the cigar back in his mouth and he said, ‘We don't want nobody that nobody sent.’ This was the beginning of my political career in Chicago.”

-Abner Mikva former congressman, federal judge, law professor, and Presidential Medal of Freedom winner

I love this story of Chicago politics. It can be applied on so many levels, yet fundamentally it is all about who do you trust and how trust is established. The world changes when volatility and uncertainty reach extremes. Trading in pits through open outcry creating a trust environment. Using voice for transaction also creates a trust environment. When trading is done through anonymous algos, trust is based on an assumption that every other trader is the same. There is only an impersonal relationship. It is easier to pull the plug on an impersonal network.

The relationship networks that you use for transactions adapt to a new world. If volatility and uncertainty increase to high enough levels, technology may revert to the old and not use the new. For example, the ICE swap rates used across different 13 dollar maturities have only been published intermittently in March. It has been hard to get good firm electronic quotes. It is not the fault of ICE but market-making changes when there is too much volatility. Market-making capital will be conserved for “friends”. Quotes are being made by voice and those voice levels may vary by customer. 

Financial networks are shrinking to those you know and trust, and there is less business available in some venues through algo pricing. Anonymous algos are being turned off in order to conserve capital for higher quality clients. It is also being turned off for smaller less profitable clients. The conservation of liquidity is normal behavior in an uncertain world. Quotes are not firm; especially for those who are not good customers. Interestingly, pricing for standardized exchange-traded futures is better than pricing in the cash market. The old members who are part of the exchange club are more comfortable trading together than those markets that were usually over-the-counter. The exchange imposes trust and standardization. 

The value of trading relationships has returned. However, those who have been shunned will remember friends. Short-run conservation will tighten future networks which will result in a slow liquidity rebound. Counting friends is as valuable as counting profits and care is needed with finding your trading friends.

‘We don't want nobody that nobody sent.’

Gold - Serving as a source of liquidity

In a crisis, isn't gold supposed to go higher?  If central banks are exploding their balance sheets, isn't demand for gold supposed to increase? We are beyond normal behavior and have seen price behavior similar to this before. When there is a major market sell-off across all major assets, there is a shortage of liquidity and high uncertainty in fair value. Many mutual funds and ETFs are selling at a discount to NAV and some hedge funds are not providing liquidity. 

In this uncertain environment, gold serves as an asset that can be easily liquified. It can be sold immediately. Hence, there will be more selling pressure on this asset to make margin payments and raise cash. A reversal in gold prices will tell us that cash raising pressure may have diminished. Gold price behavior is always more complex than any simple inflation or crisis narrative.

The demand for cash increases with uncertainty - Causes a deleveraging shock

There is an optimal level of cash in every portfolio, but this allocation is dynamic and based on the environment. If there is more uncertainty and volatility, cash levels will go up to provide for liquidity needs and serve as a store of value versus other assets. As volatility and uncertainty increase, what is considered a safe asset or cash substitute also changes. Safety may move from bonds to currency.

If we are in a risk-on environment, cash levels are minimized. If the economy switches to a risk-off environment, wealth is switched to a safe asset like bonds, but there may not be a significant chance in cash levels. If we move to a recession and there is a further increase in uncertainty, cash levels increase, but it may be through increases in bank deposits or money funds. If there is a banking crisis, cash levels will further increase, but a greater portion of wealth may be held in currency and not with bank deposits. Finally, if there is a true pandemic and real economic shock, cash as well as goods will start to be hoarded and all financial assets will be avoided. 

The impact on the financial system increases as cash levels increase because there will be a financial deleveraging shock. Cash increases force a decrease in financial leverage both through the banking and non-banking financial system which leads to a deflationary feedback loop as assets are sold to raise cash levels.

Central banks and governments have to use their powers to offset the natural consumer tendencies to increase cash when faced with uncertainty and stop the threat of a deleveraging shock. 

Volatility in a pandemic world - we will have to wait for the decay

Option volume is at sustained highs. Volatility (VIX) is at Financial Crisis levels. The daily change in volatility is off the charts and the volatility of volatility has exploded. The reason for this is the continued stream of unprecedented and unexpected news that has to be processed in real time. Markets are being driven by a single common factor. The unprecedented but occurring on a rolling basis:

• Monetary policy changes - The Fed takes yields to zero, increasing lending facilities and opening up another round of QE. Similar actions are being taken by other central banks. 
• Fiscal policy changes - The fiscal policy changes are consistent with a global war. Certainly, the fiscal actions around the world are greater than what was undertaken during the Financial Crisis.
• Global pandemic - The scale has dwarfed anything that has been seen before in the speed of contagion.
• The real economy - Shutdowns that vary across state and country creates a rolling process of uncertainty. The impact as measured in data is highly uncertain.

There has been a feedback loop of pandemic news, policy response, more pandemic news, and then further policy responses. If the contagion is going exponential, the responses are coming with similar speed.  The result is more tail events as the distribution for market behavior shifts with the new environment. 

So, when will this change? With time, the number of reported contracted cases will decline which will result in a decline in volatility because the pandemic policy feedback loop will stop. This is not the same as saying the economy or the stock market will return to old level. It also does not mean that there will not be further individual stock declines. There will be a volatility decay function like in other volatility spike cases. 

The common factor causing volatility will decline, so the common cause of market volatility will decline. There will be a switch from common factor volatility to greater stock market dispersion based on who is a winner or loser.  

Intelligence is not rationality and there is a continuum for both - Thinking beyond behavioral biases

If there is a continuum of intelligence, there can also be a continuum of rationality or sensitivity to behavior biases. Some investors are more intelligent than others and some are more rational than others. This dual framework assumes that intelligence is not the same as rationality. In the vernacular, the smart guy may lack common sense. So, you want to find the investment manager that is both intelligent and rational. (See Smart does not mean rational - Need to think beyond SAT)

That some investors are more intelligent than others is accepted as an established fact. There is no big deal here.  We have a battery of tests that rank people based on their smarts. Less smart people should not run money and the market is driven by those that are smart. 

The same idea of a continuum should be said for rationality. Some investors are more rational than others. The fact that behavioral bias tests show that some people, perhaps a lot, show biases should not be surprising. There is a continuum with some being more rational than others. 

If we can train to increase intelligence, we can do the same for rationality. Similarly, if we can choose on intelligence, we can also choose on rationality.

If we tested portfolio managers for intelligence, we will find a spectrum. It is likely, or we hope, that the dispersion of that spectrum will be tighter and higher than the general public. If we ran a battery of tests on rationality to find the degree of behavioral biases across managers, we should find similar results. 

Similar to intelligence tests, there is a minimum standard necessary for success with respect to rationality. You do not have to be super rational. You can have biases. You just have to have a minimum level of rationality to be functioning within the investment world. If you have more than the minimum you should do better, but the number who are significantly better will be limited. 

The combination of intelligence and rationality is what makes a truly successful portfolio manager, but we don't know the right mix between these two factors or how the two may trade-off. I may be highly intelligent, but rationally deficient, yet function well. For example, I make behavior mistakes and I am aware of these shortcomings, so my intelligence tells me to develop rules and maintain a minimum level of diversification. Alternatively, I may not be as smart as many other managers, but I could be very rational and avoid mistakes. I don't have to be a genius if I am disciplined and minimize the behavior mistakes. 

In the current world, do you need more intelligence or rationality. Right now, I would put more weight on the rationalist who is aware of and combats behavioral biases. This is not a time for deep thinking although it will be needed as we move beyond the current initial chaos. The importance is on not making mistakes, avoiding biases, and reacting in a disciplined manner consistent with the information.  

Check the financial plumbing, this is where the worry should be centered

Watch the plumbing and not the liquidity. It is the flow of capital and funding not the stock that matters. There can be a liquidity crisis which requires cash, but the stress resides in the movement around and through a complex system.  Complex systems such as the short-term macro financing apparatus are sensitive to breakage when volatility is high and time for repair is short. One markets problem will spillover and contaminate other markets. Margins are being raised, new collateral is required, and funding is needed to allow markets to function. This is not a pricing problem but the ability to meet funding obligations to continue market functions.

If the structure has barriers for the free flow of capital, then pricing will deviate from fair value and financial signaling is diminished. Relative value trades and risk management can be properly implemented if pricing is not representative of true value. 

Our check of liquidity and funding stress spreads show the worst plumbing issues since the Financial Crisis (FC); however, the Fed stress indices through March 13 have spiked and are heightened, but still below 2015-16 levels. We expect these numbers to spike further. Unfortunately, the composition of these indices often does not measure key stress issues.

Using the monetary bazooka - What do we have to reload?

"If you have a bazooka in your pocket and people know it, you probably won't have to use it." - Hank Paulson Treasury Secretary during the 2008 Financial Crisis

Jerome Powell took the bazooka out of his pocket and started firing. The question is whether he has any more ammunition after lowering rates to zero, increasing repo lines, reopening Treasury and mortgage purchases, and initiating a commercial paper facility. He has used almost all of his power although there are further regulatory actions the Fed can employ to facilitate lending and liquidity. 

Markets under a highly uncertain environment may not respond immediately to this stimulus. Lending is based on ability of the borrower to generate cash flow as well as rates. The Fed can reduce the cost of borrowing and provide facilities to improve liquidity. Funds should flow but there still has to be the animal spirits of optimism for lending to occur. 

There can be quibbling about using too much too early, but in a potential crisis waiting is luxury and may only force the problem to be larger in the future. Like emergency triage, there is a chance we can create long-term harm in an effort to provide immediate relief. Right now, the focus is on macro risk minimization.

Geopolitical battle for oil - The other shock

The fall in crude oil prices is driven by more than a decline in demand. It is an intersection between private and state-controlled natural resource companies struggling for market dominance. Call this the battle of oil commodity mercantilism, state firms fighting for control, and privately funded firms suffering as active non-combatants. 

Private companies through US frackers are now the dominant producers of oil, and the state-run companies don't like it. Private firms are not innocent in this fight but as small firms they are driven by marginal cost considerations and the demands of their shareholders and lenders. State firms are bigger players, yet they cannot bend the will of global oil consumers when they lose market share. 

Saudi Arabia wants state firms through OPEC to control and stabilize prices. Russia would like to gain market share and further control of European markets. Standing in their way are the private frackers who have ramped up production through a combination of technology and old-fashioned leverage. 

While this is a Saudi-Russia quarrel on the surface, there is private firm fall-out. With a demand shock forcing prices lower, the state-run firms have an opportunity to grab market share and put the private producers out of business through using their lower marginal costs and higher financial pain thresholds. Although this may not have been conceived as a master plan earlier this year, the situation has evolved. Russian intransigence on production cuts has caused a Saudi production increase response to teach Russia a lesson on market power. The collateral damage but added benefit from the view of both Saudi Arabia and Russia is fracking shutdowns. A combination of higher marginal costs and high leverage make these firms vulnerable even if they have engaged in aggressive hedging programs. Forcing prices lower in the short run is possible through having deeper cash reserves and the ability to borrow. Those refinancing and funding in the high yield market will be casualties. 

This is all the result of state-controlled commodity mercantilism dominating the oil market. It is not a fair fight if you don't have the state backing you; however, the solution is not to play to the behavior of the mercantilist, but rather use innovation and technology to break the knot of state control. 

Market stress - Margin plumbing matters

Two critical issues that drive the plumbing of financial markets are financing rates and margin. By lowering the short rate by 50 bps on March 3rd and 100 bps on March 15th, the Fed is attempting to relieve financing pressures, but what may be as critical an issue is the margin and collateral necessary for levered trades. Rates may be headed lower, but margins are moving higher. 

A close look at the changes in initial and maintenance margin shows significant increases from the CME clearinghouse. For example, after the close of business on March 9th, the bond contract saw initial margin go up by over 20%. The next day SPX stock index contract margin increased 10%. Overall, there were increases across the board in almost all markets. Margins do not fully reflect the increase in short-term volatility which by its nature will cause position cutting and more money flows out of margin accounts.  

Notably, clearing firms may be raising margins even higher. While this may not be a critical issue for hedge accounts, it is a problem for speculative accounts especially for relative value hedge funds. Cash has to be raised in trading accounts when margins.

The impact of margins increases has been studied by a number of researchers. The findings are mixed. It cannot be said with certainty whether prices will rise or fall on a margin increase, but we can conclude that there will be an increase in volatility and a decline in liquidity 

When margins are increased by the CME, there is a corresponding increase in clearing firm margins. Clearing firms may further increase margins to have excess cash cushions. Money will have to be moved into accounts especially for traders who are wrong-sided. Marginal positions will be closed. Margin increases are a natural response to higher volatility, but there will be a further shake-out that will spill-over to overall liquidity. Feedback effects can be significant. Higher volatility leads to higher margin which leads to higher volatility. This just one issue that cannot be solved by lower rates. Micro market structure matters and should be followed closely.

The risk parity approach - Ouch!

The simple risk parity approach is a long-only equal risk-weighted allocation across equity, bonds, credit, and commodities. The portfolio will have a targeted volatility which may require leverage. This portfolio will usually have a higher dollar allocation to bonds given the relatively low volatility versus equity. There are different rebalancing approaches that will impact returns, but the overall strategy will be have a similar framework. 

Risk parity funds were down between 3.5 and 5% as measured by the HFR risk parity indices through the end of February.

The asset class returns, except for rates, are all negative for March. There was little diversification benefit across asset classes beyond sovereign rates; however, the real problem was the volatility and correlation shock to these strategies. Bonds have seen an increase in volatility this year of 3.5 times while stock volatility has increased 6.5 times since the beginning of the 2020. The volatility numbers have doubled this month. At the same time, correlations across asset classes have also more than doubled. 

Leverage has hurt these strategies and volatility targeting has forced selling into the market across all asset classes. Loses have been booked for larger positions and de-risking will not allow for future gains. Being short volatility has helped accelerate overall market loses. 

The component ideas behind risk parity make sense, accounting for volatility and correlation contribution, volatility targeting, and systematic rebalancing; however, without a mechanism for adjusting asset allocation, investors are subject to sharp declines in return.

The end of the line for 60/40 stock/bond allocation?

The best asset allocation since the Financial Crisis was simplicity - the 60/40 stock bond mix. Could this month mark the end of the line for the classic mix? We are getting close and have reached the tipping point. This does not mean that a core stock bond allocation is not a good decision; however, it is now time to look beyond the simple and think about broader diversification and yield choices; nonetheless, this is especially difficult when there is a common shock that increases all correlations. The problem is threefold, rates, credit, and diversification.

On an absolute basis, yield is extraordinarily low across the curve. There is no yield cushion form bonds and bond durations have extended significantly. There is more bond risk with each cut in rates by the Fed. 

Additionally, the reach for yield through credit has been reversed with the slowdown in economic growth. There is now a much higher price with holding credit spreads. Credit benchmarks for both investment grade and high yield are down 10% in less than a month.

More importantly, especially with this week, there has been a breakdown in the negative correlation between stocks and bonds. Stocks fell and bond yields actually rose. The core premise of holding the stock bond mix has been the hedge benefit from holding bonds that have also gained in value over the market rally. The link of having bonds as a hedge may be broken. So far this month, some of the other diversification choices have fared worse than the core benchmarks. There have been correlation reversals in the past, but this week is a warning sign that all is not normal.

What is the choice for investors in a rising correlation market? The choice that may be most effective is tactical asset allocation in the form of trend-following. Holding a fixed allocation portfolio expecting normal correlation may be dangerous. Action and adaption in a changing world may be a safer alternative. A trend approach can move to safety and then to risk-taking based on price signals. Care has to be taken given the current high volatility, but active allocation decisions may offer the best protection when relationships of the past do not hold. 

From Globalism to Isolationism - COVID-19 changed the world in one month

There were already signs concerning the end of globalism, but the last month has finished off the core idea that connection across the globe would made for a better economic world. The new standard is to be disconnected or isolated, and a safe distance from others. Governments are imposing isolation on people, but companies and individuals are changing their perception of engagement. The external force, COVID-19, is the primary cause, but this change in perception is not a trend that will be reversed in weeks. As death tolls rise, the cost of physical engagement rises and the desire for connectedness will further diminish. 

We are not saying that everyone should go about their business when faced with a pandemic, but broader cultural perceptions are bending, work behavior will change, and there will be a further focus on how to protect oneself through not physically engaging with other people. You don't need to shop in person, food can be delivered, meeting and school can be done remotely, and large group activities are discouraged. This may be the greatest cultural adjustment since WWII.  

The greatest impact may not come from the failure of working from home or taking classes on-line, but from the potential success of this experiment. What if people get comfortable with isolation? 

Many businesses have a vested interest in connection and globalism, but that can quickly change. The burden will now be on those who argue for engagement and connections. As much as we can point to cultural resilience after adversity, there have also been key examples of major shifts in thinking that regress or veer into the unexpected. The challenge is not to think about when markets will come back but what is the form an economy will take if there is a new world of isolationism.  

Back to basics - Higher risk aversion will change risk premia

When there is greater downside uncertainty, there is an increase in fear. We can say that fear in a formal sense is an increase in risk aversion. An increase in risk aversion will have a negative impact asset prices like an increase in volatility. There is some subtlety with how risk aversion impact prices but there is a general acceptance that risk aversion is countercyclical and will impact equity premia.

An increase in risk aversion is manifested through caution, higher avoidance of risk-taking, greater emphasis on safety, and hoarding of safe and necessary assets. In this case, there is increased buying of Treasury bills, hand sanitizer, and toilet paper. 

We have discussed the repricing of risk (see The week the financial world changed - A repricing event), but there is also a resetting of risk aversion in both our real and financial lives. Everyone will be avoiding crowds and being more careful about health. This is all for the better, but it will also translate into different financial risk-taking and will change the behavior of markets. Simply put, more return will be necessary to hold risky assets. There will no longer be a reach for yield but a demand for risk compensation. Instead of asking for yield, there will be an asking for compensation.

Risk aversion also increased during the Financial Crisis, but the Fed and government were able to shift behavior through flooding the market with liquidity and use regulation to increase confidence. Government will be needed again to bend risk aversion, but the policy responses will have to be significantly different. Liquidity without health certainty will be ineffective. Real economy fiscal support without pandemic dampening will only be marginally effective.

Managed futures trend-following, 60/40 stock/bond allocation and crisis gains

Managed futures trend-following has been a hated strategy for many investors. Weak performance with the maligned attempt at marketing jargon, crisis alpha, made for tough days for these managers. Nothing with trend-following strategies have changed, but the markets are different and that matters a lot. 

The post Financial Crisis was characterized by increasing equity prices, falling yields, and no inflation. It was a perfect environment for holding a 60/40 stock bond mix. There were no extended equity declines so long/short trading was whipsawed. The negative correlation between stocks and bonds smoothed returns but the falling trend in yields supported the hedge.

Now, we are in a different environment. An almost bear market in equities over a period of less than 2 weeks and an ultra-strong rally in bonds. Trends are now offering advantage. Using an 80-day moving average for a long-term trend with SPY and IEF as the equity and bond choices (the same results would occur with 20 or 40-day), March would be a great month for trend-followers. Any variation on trend would effective. Even if holding a more diversified portfolio the result would be the same. 

Crisis protection from following trends has been supportive for investors. Down trends that extend over time because risk is revealed slowly is positive for trend-followers. Whether this continues is not critical. The trend exposure provided protection and bought investors time to make strategic allocation changes. 

The week the financial world changed - A repricing event

The classic approach to most forecasting is to create some extrapolation of existing data trends. There are many ways to extrapolate and model data, but all are based on some weighing of the recent past. Nevertheless, there are a few periods when there is a wholesale repricing of risk. The repricing event can be, for example, a financial crisis, a structural economic change, or a significant supply shock. We are at one of these repricing inflection points. 

Risk repricing wipes away the past and causes asset prices to move in a different direction from yesterday's environment. This repricing can be temporary, or it can be a large shift that lasts beyond days or weeks, but when it happens, past data cannot be extrapolated and is almost useless. The defining of rational expectations is when investors realize that the past is not helpful for predicting the future.

The COVID19 scare is now one of those repricing events. Labor markets or consumer confident from last month has no value. P/E has no value. Sales trends have no value. We are in a new world. All market behavior and investment decisions should be viewed through the filter of a repricing event.

Are CTAs too rigid?

“When different CTAs were each exploiting their own way of trading trends, their performance was great. The aggregate performance of these independent traders set the name for successful trend following. However, the moment this was recognized and sold as a style, the unlimited discretion of the traders became bounded by an overly rigid definition. CTAs embraced this loss of freedom, partly because investors and their advisors liked them to be easily defined. Conformism, or essentially lack of unorthodoxy, led to decay in performance.”

-from the head of research and development at Transtrend Harold DeBoer 

https://thehedgefundjournal.com/transtrends-harold-de-boer/

This is a provocative comment on the state of CTAs from Harold DeBoer of Transtrend, a long-standing successful CTA. It is also a battle that has been fought for decades. Stick with a model or change. Be a singular iconoclast or adaptable manager. Be a hedgehog or fox. Focus on a style or just try and make money based on perception of what should work now. Was this solely the choice of the manager or was it foisted on managers by an investor base desiring categorization.

I have spent long hours with managers who stuck to the same model. I have been around those who have followed a policy of kaizen, incremental improvement. I have listened to those who followed their "feel", and those willing to hold onto winners and cut strategies at the first sign of failure. The evidence on sticking or switching can be marshaled in either direction. Trend-following and momentum clearly has worked through the decades, but that is not same as saying that it will work all of the time or that blending won't provide value.

What is clear is that sticking to a strategy versus being flexible is a manager's preference or choice. It is a part of their personality. Some are comfortable with change and others are not. An investor has to ask questions about this preference and understand the manager style comfort.

However, DeBoer makes an important point. With the hedge fund market increasingly institutionalized, there has been a greater demand for categorization. Managers have to fall into a style box. There has to be a benchmark. If you are not in a box, no one wants you, and heaven forbid the manager who changes style. Just watch the asset fly out the door if the long-term trend manager becomes a shorter-term trade. The momentum guy who adds carry better be ready for the calls, the placing on watch, and possible redemptions. 

There is limited freedom to innovate once classified. It is no longer just a manger's investment preference, but a penalty imposed by the outside as a business cost. Call it the "Innovator's Dilemma" for CTAs and all hedge fund managers. Once typecast, it is hard to try other ideas. This will be costly for investors.