It’s only when the tide goes out that you learn who has been swimming naked. - Warren Buffett
The ongoing Covid-19 health crisis, the economic crisis, and the financial market turmoil represents a time period when the tide went out. Such periods are an excellent opportunity to discover paradigm shifts. Below are observations from the first half of 2020 related to potential paradigm shifts in the investment world.
1) What was up with market volatility in March 2020, no pun intended?
Reminiscent of the initial stages of the 2008 financial crisis, equity market volatility spiked to extremely high levels in March, triggered by the Covid-19 health crisis. However, I was surprised to see implied volatility, as measured by the CBOE SPX Volatility Index (“VIX”), remain above 50 for over three weeks.
Yes, a global economic crisis was underway. Equity valuations were stretched. Corporate debt, by many metrics, was at historically high levels. Some investors were levered. But it wasn’t as though a banking system collapse was on the table like in 2008. A VIX sustained at levels above 50 means that a complete market wipeout is within a normal range of expectations. So why did VIX remain so high?
Not so visible was turmoil in the world of volatility trading as recounted in a fascinating Institutional Investor article. The article was a good reminder of the danger of stretching for returns via complex, illiquid, opaque, levered strategies which are net short vol. These types of activities explain why VIX remained so high for so long. And such periods, where VIX remains elevated at very high levels, are likely to occur again in the future as volatility trading continues to grow.
2) Is following the trend always a convex friend?
Yes, trend following is a convex, i.e., valuable, friend most of the time. It makes a portfolio more resilient so investors can withstand the emotional turmoil of severe market declines. It comes with no upfront cost. It even performed well during the 2008 financial crisis.
But as Nathan Faber noted, during sudden, sizable market reversals like we witnessed in March 2020, a much better convex friend is a long position in equity option straddles. However, option insurance has upfront and ongoing costs, which may be incurred for an extended period without a corresponding large payoff. March 2020 reinforced the benefit of incorporating a multi-layered risk management strategy within portfolios, because every single faceted strategy has a weakness.
3) Is gold telling us anything about the central bank’s balance sheet?
According to the London Bullion Market Association, gold prices have 16% year-to-date through June 25, outperforming all major asset classes, except long maturity U.S. Treasuries (20+ year maturities). But what caught my eye was the recent shift in composition of gold demand, with investor purchases representing almost 50% of demand. See here.
We will be watching demand trends closely as they hint at concern about the implications of recent expansion of central bank balance sheets, especially the massive expansion of the U.S. Federal Reserve, as we discussed here and here.
4) What is supply chain financing and “reverse” factoring?
I continue to be amazed at the ability of financial engineers to “invent” new techniques. And disappointed the creativity is not directed towards real innovations which will enhance productivity, add to the capital stock of the global economy, improve social welfare, help restore the environment, and sustainably increase corporate earnings.
U.K. start-up Greensill, a Softbank “unicorn”, created a business model providing supply chain financing to companies. Three of those companies have collapsed due to undisclosed debts and accounting scandals. Greensill effectively financed accounts payables for companies, allowing them to distort their cash flow statements and balance sheets. See here.
Factoring, or financing accounts receivable, makes sense to me. For example, AECOM, a U.S. engineering company, has significant contacts with the U.S. government, which is well known for being slow to reimburse companies for completed projects. AECOM has often financed those receivables to access cash. It struck me a low cost and transparent way to borrow. But “reverse factoring” or financing account payables? The business rationale does not resonate with me. I anticipate financial engineering will continue, but many implementations will be perceived less favorably going forward.
5) Are CLOs (collateralized loan obligations) the new subprime?
I don’t have an opinion on the magnitude of the losses that will be experienced by CLO investors. I do see a parallel to the subprime residential mortgage lending fiasco from the 2008 financial crisis. In both situations, lower quality collateral was repackaged via securitization to create higher rated, “higher quality” debt securities.
In most economic environments, the higher-rated debt securities will act like higher quality debt securities. However, in economic and financial crises, the securities will exhibit an unpleasant non-linearity. At some tipping point, if the economy deteriorates sufficiently, the correlation between the underlying loans, i.e., subprime mortgage loans or leveraged loans, will increase. Defaults will not increase linearly, but closer to exponentially. I find this recent article to be timely.
6) Will global supply chains be significantly transformed?
I believe the answer if yes. If I am correct, it will have large implications for revenues and profit margins of many companies. I touched on this issue in a previous blog. An INSEAD’s article expands on the topic of the future of supply chains. It is an issue we will be monitoring closely at TCI.
7) Is the urbanization trend over?
Urbanization has been on an upward trend in the U.S. for over a century. See here. Will the Covid-19 health crisis reverse the trend? The rate of urbanization was already slowing, which is no surprise given the urban population have risen over 30 percentage points since 1900 to 80%. However, any slowing of urbanization will impact the revenues and profit margins of companies, since most are positioned for continued urbanization.
8) Is the Covid-19 crisis the critical take-off point for WFH adoption?
Work From Home (WFH) is the paradigm shift which came most readily to mind. Will it follow the S-shaped adoption curve which applies to virtually all innovations? With the advances in technology, particularly video conferencing, the prevalence of work from home will accelerate. As pointed out by Global Workplace Analytics, with less than 5% of the U.S. workforce working from home and with 50% to 60% of the U.S. workforce potentially capable of working from home, there is plenty of room for the trend to accelerate. I am most interested in the impacts to employers in terms of innovation and employee productivity.