VIX index - In case you don't know, it is a non-normal distribution

The VIX move last week was large with current levels the highest since 2011; however, it should be remembered that the VIX does not behave according to a normal distribution. It has a very skewed distribution with the center of mass in the mid-teens level. This skew is more likely than what would be expected with a standard normal distribution. The data from Harbourfront Technologies provides a good look at the non-normality.

It is inappropriate to think of the large move last week as anything like a normal event. It was an extreme but cannot be placed in the context of a normal distribution.

Credit risk - just as big an issue as equity risk

The credit markets have seen significant outflows from high yield ETF as credit investors have exited for safety. The result is as expected, a significant increase in corporate spreads. While spreads for BBB and high yield are still lower than levels at the beginning of 2019, the concerns over liquidity and flows are significant and should be accounted for in any portfolio adjustment. Liquidity in credit markets are being tested in ways not seen since the Financial Crisis.

The 5-day spread widening for high yield was 27% and just under 16% for BBB. These are the largest weekly increase over the five years shown in the chart. It is the biggest percent change for high yield spreads in a month since 2000. This is the greatest percent change for BBB spreads since the Financial Crisis.

High yield sectors such as energy have been especially hard hit given the sharp decline in oil prices, a 25 dollar decline since the beginning of the year for oil futures. While it seems like BBB have fared better, many investors are dumping marginal names to get ahead of any downgrades. 

The spread widening has been masked because of the declines in underlying Treasury yields. The bond AGG index is still positive for the year, but the difference between it and Treasury indices is off significantly. The negative adjustments in credit markets are real. 

Equity performance choices - Limited safety

There was limited protection in equity market factors from the COVID-19 sell-off in February. A low volatility index actually underperformed the SPX benchmark in February although it still showed better returns year to date. A growth-focused index outperformed value for the year, but a surprise result has been the protection from holding international and emerging market equity benchmarks. The high valued US market has been taken down into a correction by a virus.

When there is a common factor impacting all strategies, as expected, there will be increased correlation within an asset class and there will be limited diversification benefits for investors.

Follow the precautionary principle for health and create a sick global economy

The precautionary principle states that if faced with a weakly understood choice of high uncertainty or risk that can have catastrophic or irreversible results, policymakers should error on the side of caution. Follow a “better safe than sorry” policy. This is especially true when there is even a small probability of large failure or an infinite mean and variance with measured probabilities. The burden of proof should be on those that do not want to follow the cautious approach. 

With respect to COVID-19, the policy approach will be to use caution and take added precautionary measures given the high level of uncertainty. The health impact is unclear since it is unknown what is the correct containment policy, but the immediate economic impact is more obvious. China will be in a recession once we have the numbers, Korea and Japan will likely follow, the EU will have a slowdown, and the US will not be an engine for growth. The extent or form of these cautious policies could be debated, but there is a clear economic cost of throwing the global economy into a recession. A recession for the global economy as defined by the IMF is a fall in growth below 2.5%.

There are limited policies to offset this supply shock and the longer virus persists the more likely there will not be any V-shaped recovery. Supply shocks cannot be solved by lowering rates. Consumers cannot be enticed to buy more if they do not live their homes. Investments on the margin will not be made, sales cannot be improved, earnings cannot be jolted, and financial assets cannot be supported. As bad as the supply shock effects, the impact of consumer confidence may be even greater. Economies thrive on optimism for investment and consumer spending. If the virus threat is long and more persistent, then the impact from economic pessimism will be greater.

A high level of precaution will have an immediate negative impact on the global economy under the expectation that economies can be saved over the longer run. Less caution today, potential for greater economic threat tomorrow. More caution today, greater immediate economic impact but lower risk tomorrow.