Risk Update: March 2020 – House of Cards.

Our thoughts on the world rarely change! Endogenous risk builds in the system over long periods of time, eventually becomes unsustainable, then corrects. Generally, everybody wants to blame the correction on some seemingly unforeseeable exogenous event and claim that it is a never before seen and utterly unknowable oddly coloured animal. The builders of the house of cards claim that they can’t be held responsible for the wind that blew it over (again). The build up of risk is forgotten, only the event is to blame.

Not hard to imagine that this cycle, at peak all time global credit outstanding after a decade+ of unprecedented monetary accommodation, might eventually find its exogenous shock. The shock was of course in the form of a pandemic.

And a hell of a shock this one is too. At peak all time credit obligation around the globe, you get a near simultaneous global shock to cash flow on an unprecedented scale, which quickly feeds into a sharp reduction in collateral values as asset prices drop a swift 20-30%; a double whammy on the carrying capacity of all that credit. Inevitably, Central Banks jump in to bail out the owners of assets/providers of loans, taking us from the all-time greatest level of accommodative policy to twice as much again in the matter of days. Then governments jump in on the fiscal side (or is it really CBs jumping over to the fiscal side given the near direct monetization of debt?) and provide even more bailouts for lenders, hidden in plain sight packaged with much smaller support for unemployed workers. The core problem of too much debt, its unsustainability relative to output/cash flow gets worse, but asset holders and lenders don’t need to account for any losses.

Yet, history thus far tells us that the cycle always ends. It is always the same, yet always different. This one comes with the uniqueness of having been, by various measures, one of the longest cycles in history, accompanied by uniquely extreme and coordinated monetary facilitation the world over. Stupid uncapitalized risks that were in the hands of banks last time around, are now in the hands of fiduciary asset managers and even end retail investors. The pandemic shock impact on cash flows to the real economy is maybe even more significant than the correlated home price declines were to the financial sector last time. One never knows, but last time the market recognition of the “problem” commenced in August ’07, was met with an endless array of central bank and government responses, and the end-of-cycle ‘cleanse’ finally ended in March of ’09, with every major bank in the world requiring a bailout along the way. It is ok to be sceptical that, if indeed recent events have triggered the end-of-cycle cleanse, we will have worked that through the system over the period of Feb 23rd to March 23rd. One could equate what we just went through with the top that was put in, and the initial vol expansion, in August 2007. The cyclical highs in vol didn’t occur until 14 months later, and the market lows weren’t in until 19 months later. That seems a reasonable starting point to work around. You can look at a lot of things to try to get your head around that sort of mindset, but 1yr USD/JPY implied volatility makes a good visual, where Aug ’07 and Mar ’20 are spitting images of each other. Just for fun, we’ve also circled the similarities between May ’06 and Dec ’18.

Figure 1: USD/JPY 1yr Implied Volatility
Source: Bloomberg

Another version of the same concept, this time with SPX Index (in log format) and Fed Funds added. Again, there are some uncanny similarities to the timing. The early market hiccups in May ’06 and December ’18 are both met with the end of Fed rate hiking cycles. The initial turns down from the cyclical SPX highs in August ’07 and March ‘20 are met with quick and accelerating Fed rate cuts. The aggressive Fed actions only temporarily halt/reverse the end-of-cycle risk unwind post August ’07. The unwind continues in stages, met by ever more extreme policy measures to stop/mitigate/reverse it, but in the end the unwind takes place before the market begins its next long term recovery.

Figure 2: SPX(log), USD/JPY 1yr Vol, Fed Funds
Source: Bloomberg

If one thinks we are indeed into the wildfire season, and this is the fire that will spread (correlate) and burn up all the neglected dry brush around the forest, then the trick is to understand where the biggest risk is, where will the fire, if it spreads, do the most damage. Using credit as the proxy for combustible material, the biggest risk is in EM, with a particular uniqueness as regards China and related areas. The other big risk, and this one was laid reasonably bare in March, is carry. As we’ve been saying for some time, the world has become one big LTCM. Low correlation on the upside, high correlation on the downside, and lots of leverage. Why the Fed feels it is justified to bail out the takers of such risk is beyond us.

As a quick reminder of the status of China’s ability to forever hold all things steady, we append our old favourite of FX Reserves divided by M2 money supply.

Figure 3: China FX Reserves/M2
Source: Bloomberg

As we projected in last month’s note, if things got bad, the illustrious policy makers would throw the whole works at trying to get the fire under control. As of this writing, the Fed has slashed the Fed Funds rate to zero, gone to Unlimited QE and expanded their funding and/or buying of fixed income assets to encompass, well, pretty much the entire universe. This was, give or take, matched by Central Banks the world over and has had the desired effect of stopping the meltdown in asset prices, and even triggered the fastest return to a bull market ever. This leaves the financial world in a strange sort of limbo. As the real world economic impact of the virus-imposed shutdowns deepen what now looks likely to be a decline on the scale of the Great Depression, asset prices, equity and fixed income alike, all retraced back to the neighbourhood of all-time highs. The below chart of SPX (logged) and US Initial Unemployment Claims puts the real world impact in perspective, and this is after just the first such report post the virus related lock downs. It is most likely going to get a lot worse.

Figure 4: SPX Index and US Initial Unemployment Claims
Source: Bloomberg

As always, we don’t claim whatsoever to know what is going to happen. Can Central Banks, and their monetization cohorts on the government side, forever maintain the historical extreme levels of wealth segregation that they have worked so hard to create, and avoid the traditional rebalancing of wealth with a good old-fashioned, recessionary debt reduction/default cycle? Maybe. Just because it has never happened before, doesn’t mean it couldn’t happen this time. Still, there must be some prudence to considering the possibility that this cycle, like all other past cycles thus far, will go through some sort of wild and wooly cleansing of risk. One thing worth noting, it is rarely the part of the forest that burns earliest that burns the hottest in the end.

A couple of interesting visuals. From May to August of 1997, the early dislocation of currency volatility kicked off fast and furiously in USD/THB, significantly outperforming the equivalent realized volatility of USD/IDR. As the cycle unwind continued the fire spread to the bigger risk and USD/IDR realized vol exploded to rarified air 9 months later.

Figure 5: 3mth Realized Volatility USD/THB and USD/IDR
Source: Bloomberg
Figure 6: 3mth Realized Volatility USD/THB and USD/IDR
Source: Bloomberg

An analogous version from the more recent “Great Financial Crisis” can be constructed with SPX volatility and USD/KRW FX volatility. In the initial dislocation, SPX volatility (using the 6th VIX future as a proxy) significantly outperformed KRW FX 6mth implied volatility. Yet again, however, by the time the fire had worked its way through the winding hills and canyons to the most vulnerable parts of the forest, it eventually found the massive pile of dry brush hidden in the structured product minefield of KRW FX.

Figure 7: 6th VIX Future and USD/KRW 6mth Implied Vol
Source: Bloomberg
Figure 8: 6th VIX Future and USD/KRW 6mth Implied Vol
Source: Bloomberg

What does it all mean? Policy makers could yet ‘save the day’ and extend the cycle, in which case you want to own assets. Perhaps this is the beginning of the end of the cycle reckoning. Quite simply, we continue to espouse the same investment idea, a barbell portfolio of things that participate in the upside cost efficiently (ie don’t pay for correlated returns!), paired with things that are efficient, negatively correlated, and highly asymmetric in the correlated risk unwind. That strategy will invariably outperform, over time, on a compounded basis. Sadly, it is very rare that fiduciary managers are measuring, much less managing their greatest risk, correlation, nor are they targeting geometrically compounded returns, but rather arithmetic short term returns. The focus is performance at the mean, and the compounding that is driven in the wings gets destroyed over time.

Figure 9: SPX Volatility & Correlation Comet
Source: JP Morgan, Convex Strategies
Figure 10: SGD/JPY Seasonal Chart
Source: Bloomberg

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