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Market call difficult in generation-defining moment
IT'S hard to believe, but in just more than a month, US stocks, as measured by the Dow Jones Industrial Average, a widely followed albeit partial and imperfect proxy, have gone from a record high to the fastest correction in history to the best week since 1938. Driving these moves to a great extent were the contrasting investor sentiments of complacency at first and then panic. If you can correctly characterise the week's strong rally, you hold the key to what lies ahead.
The Dow hit its record on Feb 12 despite mounting evidence that the coronavirus was already damaging the global economy. China's economy, the world's second largest, had been brought to a virtual standstill. Global supply lines had been disrupted, causing some factories elsewhere to close. International trade was falling. And the source of all this, the highly contagious Covid-19 virus, was already spreading to other countries.
Some of us had been warning for weeks about the threat of the coronavirus because it inflicted "cascading economic sudden stops", which are common in fragile and failing states but not in systemically important economies. They are highly disruptive because they destroy both demand and supply at the same time. As such, this was an urgent and complex policy priority that did not provide a "buy-the-dip" opportunity for investors.
These warnings fell largely on deaf ears, and for understandable reasons. The sudden stop dynamics, while extremely consequential, were largely unfamiliar to the vast majority of economists and policy makers. Similarly for Wall Street analysts, investors and traders who - conditioned by years of ample and predictable liquidity provided by central banks and amplified by the "fear of missing out" - had developed an almost automatic response to buy any market pullback regardless of the cause.
This combination had evolved into a seemingly can't-miss approach as central banks' ability to repress financial volatility and shield elevated asset prices from more sluggish corporate and economic fundamentals drove stocks from one record to another.
But as the coronavirus devastated more of the Asian economies, paralysed northern Italy and was reported in several other European countries, the evidence became overwhelming that this was indeed different. Company after company reported blows to actual and future profits as revenues shrank, costs increased and even people and inventory management became much more difficult. With the United States also threatened, there was no denying that this was now a serious economic shock that would have financial consequences.
Not only did the price of stocks and other risk assets fall, but they did so in an increasingly disorderly fashion. Having overpromised liquidity to end users for years, a phenomenon facilitated by the spread of ETFs and other products that provide easier access to usually hard-to-reach market segments, the system could not accommodate all those now wishing to rush for safety and cash. And the more investors and fund managers were unable to sell what they wanted to sell, the more they disposed of whatever they could. This spreading contagion caused indiscriminate carnage and threatened the very functioning of some markets. With that came the possibility of an accelerated financial deleveraging which, combined with what was happening on the economic front, threatened both a 1930s-like depression and a 2008-like global financial crisis.
The fast, sharp and particularly disorderly market correction served as a loud wake-up call for policy makers. The result was a historic "all in", "whatever-it-takes" and "whole of government" approach in country after country. In the US, this included huge Federal Reserve policy interventions and a US$2 trillion fiscal relief package.
With the prospects of both a global depression and financial crisis averted for now - a sudden and deep recession is, unfortunately, already a done deal - stock prices bounced sharply and the Dow climbed during the week, even with Friday's 4 per cent drop. But the message of this sharp move up is subject to intense debate in the marketplace.
The optimists see it as the start of a process to form a bottom that promises further gains after this year's harrowing losses; the Dow is down 24 per cent year-to-date. Supporting their argument is growing evidence of better market functioning in key segments such as Treasuries and investment-grade bonds.
The pessimists see it as a counter-trend rally, or what is more popularly called a "dead cat bounce". They point to several similar instances during the September 2008-March 2009 sharp market downfall.
It's hard to make the definitive case for either of these. There is simply too much uncertainty about the severity and duration of the underlying disruptor - the spread of the coronavirus - the extent of damage already done to economies and markets, and the smoothness of the eventual process to restart the economy.
Based on the partial information I have been assembling and updating continuously, I fear that this is more likely to prove a temporary exception to what, unfortunately, is still an outlook for high stock market volatility around a still-downward trend. As such, it is more of an "up in quality" repositioning opportunity within a strict overall risk-mitigation approach than an all-clear signal for investors.
To those who disagree, I would immediately concede that no one knows for sure. But with that comes the recognition that, with the exceptionally high degree of uncertainty associated with such unprecedented shocks, the likelihood of investing mistakes is high, particularly because policies can only contain damage, but not as quickly as needed and not in a way that immediately restarts normal economic activities.
A key question here, and not only for investors, is which mistakes are more recoverable over time. The Type I error is a premature increase in risk exposures; the Type II one is excessive caution.
Given especially that some of the risks for investors include surging corporate bankruptcies and defaults that would wipe out many levels of the capital structure starting with equities and unsecured bonds, I err towards suggesting to them that they court a Type II error rather than Type I - by selling bonds with low credit quality and moving some of the proceeds into much higher quality peers; by switching from index products in lower segments of the credit market to carefully selected individual corporations and sovereigns with high reserves and limited short-term debt maturities; by also tilting their equity exposure in favour of companies with rock-solid balance sheets; and by keeping more cash handy for potential opportunities in distressed, special situations and structured credit.
Big price correction
Given the big price correction that markets have already gone through in the last six weeks, this is a particularly difficult market call. (Yes, valuations matter notwithstanding stressed fundamentals and technicals.) I truly hope that I am being over-cautious in suggesting prudence. But I do feel strongly that we are living through a generation-defining moment and that too many are only now starting to grasp and respond as needed.
As such, "regret minimisation" should guide many of the key decisions by companies (minimising cash burn and arranging contingency financing), governments (prioritising health-care solutions aimed at quickly identifying and containing the virus, better treating its illness and enhancing immunity) and investors. BLOOMBERG
- The writer is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton.