In January 2019 I gave a presentation called “End of the Market Cycle and the Path of Prudence” discussing how to think about capital allocation given the phase of the market cycle we found ourselves in at the time.
Obviously, the world has changed a lot since – a +30% print for the S&P last year, followed by the calamitous start to this year. I have been spending a lot of time on the phone over the past few weeks with digging into the current state of markets.
Because there are so many moving pieces currently, I thought it worthwhile to summarize at a high level where markets are currently and what is going on.
S&P 500 has seen a ~25% draw-down from its peak to current levels. Markets have been volatile logging massive up and down days as the they attempt to make sense of the world.
What started this?
- COVID-19 is dominating the headlines and is certainly newsworthy. But let’s not forget the Saudi/Russian price war that destroyed the oil market just a few weeks ago.
- On March 4, Thomson Reuters reported that Saudi/OPEC were pushing Russia to support a round of output cuts. This was quickly reversed on 3/9 when Saudi Arabia decide to cut prices and boost output.
- This high-stakes game of chicken was ostensibly to put the pain trade and basically force the US shale producers out of the market entirely.
- At the time, COVID-19 concerns were focused on China, Iran and Italy. US cases only totaled 550 and 110,000 globally
- Since then, the market has fallen precipitously, troughing at down almost 34% before rallying back over recent days.
What happened next? Short answer – plumbing problems.
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market”
– James Carville
- Massive flight to quality – Over recent weeks, yields on the 10-year treasury fell from 1.13% at the start of the month to 0.54% by 3/9.
- End of the basis trade. This sizable flight to quality disrupted ‘basis trades’ in place at most large fixed income hedge funds.
- Quickly – a basis trade is when a fund buys a bond and then shorts an equivalent future to capture the difference in price between the two assets. This “spread” may be tiny so to make the trade worthwhile, a fund will lever it up aggressively. J.P. Morgan estimates that as much as $650 billion was invested in the strategy. Point being that a rapid unwinding of that amount of capital could have sizable impacts.
- In the flight to quality, many investors ran to futures markets first as they are more liquid than bond markets. This disrupted the basis trade as levered holders were forced out. Ironically this made the basis trade more profitable vs. other short-term trades like commercial paper – pulling liquidity from the commercial paper market
- Multi-strat hedge fund & risk parity deleveraging. The aggressive pullback in equity markets also puts a hurt on ‘trading pods’ at multi-strategy hedge funds. As is typical practice, when a pod shows losses, risk management kicks in and the pod is forced to delever. The moves in markets also disrupts risk-parity strategies which lever up fixed income to balance with equity risk. Nomura estimates that some such funds may have held to sell half their holdings.
- Treasury sell-off. The 10-Year next sold off from 0.54% to 1.18% in 8 days. At the core of this was extremely tight liquidity for Treasuries – leading the Fed to step in and offer to buy up to $1.5 trillion in Treasuries to help the market clear.
Now – let’s play dominoes – Where do you go to get liquidity?
- Investors have now begun a game of both liquidity seeking to raise cash / delever, as they sell off assets that are going to be impacting by COVID-19.
- Money markets – Goldman Sachs had to intervene to support two money market funds. BNY supported the Dreyfus Cash Management fund with $2.2bn last week.
- Muni bonds have been hit as investors look to raise capital
- ETFs deverge from NAV – Fixed income ETF’s have seen record differences between price and net asset value as investors sell out
- High yield spreads have blown out from 3.56% to 10.5% as investors worry about corporate balance sheets.
- Mortgage REITs – a disaster. A special type of REIT that invests in pools of securities backed by mortgages have been slaughtered. Concerns over the ability of people to pay their mortgage in the case of wide-spread unemployment has led to a sell off in the RMBS market. Mortgage REITs are typically levered owners of RMBS. They have faced margin calls on their leverage and many have been unable to meet those calls.
- Short-term Treasuries go negative – 1 and 3 month Treasuries have negative yields at the moment
- Consumer exposed CMBS? Bloomberg reporting that retail and restaurant chains are telling landlords they are going to cease paying rent. Spreads on retail CMBS index, CMBX Series 6, have blown out, the first money making opportunity for this “next big short” trade that has been nothing but pain to this point.
- $3.4 trillion in BBB corporates outstanding – This lowest investment grade rated paper likely in for a world of hurt in the event of mass-downgrades due to a recession
- $1.2 trillion in leveraged loans + CLOs – Levered loans to support LBOs and the subsequent CLO issuance to hold the paper stand at risk in the event of a protracted downturn.
- Private credit – Post the Global Financial Crisis, most risky lending moving off bank balance sheets into private credit funds. From 2013-2017, Preqin notes that 322 dedicated funds were raised – 71 from firms that had never raised one before.
The near-term panic has abated a bit – for now. With Congress close to finally approving a $2 trillion stimulus bill with aid to consumers, small business and hard hit industries, the market has rallied this week. Though the question is still out if we’ve seen the bottom yet?
There seem to be three paths people are taking to navigate this market:
- Bottom-fishing – There are a sizable group of investors who are sifting through the hardest hit companies trying to find the ones left for dead who will in fact manage to survive.
- Run to yield – With the Fed cutting interest rates to zero and short-term T-bills effectively negative, a number of investors are running to find yield in high quality paper, preferreds or large stable companies with secure dividends.
- Run to quality – While their sell-off has not been as severe, certainly some of the highest quality, most profitable companies are 20% cheaper than they were a month ago.
Interestingly, private equity funds, while no doubt facing issues within their portfolio companies, are loaded with cash in recently raised funds. This could prove to be a prescient time for deal making, though LP investors with those funds need to think long and hard about how to fund their capital commitments in a soft-equity market and a partially frozen fixed income market. Which of these paths you prefer is driven by risk appetite and need for cash, but admittedly the speed and severity of the downturn has driven some market participants to just throw in the towel.
David is the Founder and CEO of Family Capital Strategy, a strategy consultancy for family offices and family businesses based in Nashville, TN. We help families stay invested together through the design of the family office and the thoughtful development of the family’s investment program. We provide objective, conflict free advice in a strategic, customized and multi-generational manner.
Disclaimer: This does not constitute investment advice or an offer to buy or sell any securities. It is provided for informational purposes only and represents the author’s own opinions