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In light of recent turn of events and market movements I thought I would share some risk and investment related thoughts.
Having invested throughout the GFC of 2008, and navigated it successfully (I had the privileged of being part of a great team at Polar Asset Management), I think it is wise at this juncture to consider a wide range of outcomes, including the extreme ones (on both sides) in order to prepare for the months ahead.
This statement does not mean that I foresee the worst ahead of us.
In fact, both on a human and a personal level (given the geography of the spread of the virus) it is my strongest wish and hope that somehow, we come out of this episode with the least hardship and suffering for those affected.
But as practitioner of derivatives and risk I live in world of probabilities and the probability of extreme outcomes at this point are far from negligible.
In the last few days risk markets have tuned to this fact and repriced risk (as expressed through option prices) to some extent.
Living in a world of probabilities means that everything is possible and then one needs to attach a probability to it.
The most important thing for any policy maker, investor or risk manager is to do away with absolute certainties. Remember Ben Bernanke saying: "They will make it through the storm”. Two-month later Freddie Mac and Fannie Mae were nationalized.
When there is potential for a crisis and there are doubts brewing out there, the headlines that come out might very well end up not materializing, or they could actually be followed by a real crisis (in 2008 the crisis came but in 2011 debt ceiling saga or in the case of Brexit there was no doomsday).
But once headlines unleash, risk will start to be repriced and, in the process, multiple standard deviation moves can occur (both up and down) before the dust settles and a sound appraisal of the situation and the new reality ahead is made by policy makers and investors alike.
So how to look forward and be prepared?
The key is to be thinking in terms of a spectrum of outcomes and not specific paths forward. As humans we like stories and narratives so we like build “A” specific story of what is to come, because we have a hard time processing someone telling us “XYZ is possible, and oh! by the way the exact contrary is also possible!”. Many investors even in the midst of strong uncertainty will tend to make decisions based on “I am pretty sure …”, “it is very unlikely …”. That can lead to richess of some but also to ruin of many. In tumuteous, the main goal should be actually to stay in the game.
Now let us be practical and look at the spectrum of outcomes in the present situation. At the two extreme we have:
1) The happy outcome (right tail):
The virus spread subsides (or a vaccine is found in short order) and policy makers manage to help create a V-shaped recovery for the economy. Additionally, US and China keep building on phase I of the tarriff deal and many corporations would have used this dip in the market to secure their inputs (commodities, etc.) at lower prices, thus increasing profit margins in quarters to come. All in all, they will be some adjustments and short-term pain, but not only the storm is weathered and we will be back to business as usual, but things will look even brighter by resolution of tariff issues and more profits for corporations.
2) The hard outcome:
the spread of virus continues, containment efforts fail, many under-developed countries ill-equipped to manage such crisis suffer hardship and human losses and developed countries will be stretched in resources unable to efficiently help other jurisdictions. Additionally, if no vaccine and treatments are found in the short-term, the human toll can be sadly impressive. As a result, commerce, trade and travel take major hits, supply chains are disrupted and consumption falls dramatically.
The idea is that reality will not be necessarily be either of these extremes (though it might) but likely skewed to be close to either of them. That is because the risk ahead is that of an epidemic which is somewhat binary in nature (all or none: there will be one or not) making it likely that we will be closer to either extreme rather than somewhere in the middle.
Now the question is what is the ideal positioning for each extreme?
1) For the good extreme
The answer is rather easy. Generally speaking, you need to keep the same positioning/allocation and trades that you have had for the last 11 years! Happy days will resume. Also, if you think you have an edge in trading or timing, then from a tactical perspective given the adjustment in bonds and precious metals (higher) equities and commodities (lower), a rebalancing out of refuge values into risk assets at some point along the way, would help boost the performance of the portfolio.
2) For the bad extreme (i.e. left tail), here are a few likely developments:
a. Central Banks would intervene (PBoC has already) and those governments which can (i.e. some developed economies) will likely release economy-boosting packages (as China has started to do). This will be hard for many countries to do.
b. Rate cuts will result in lower rates in US & Canada in particular as they are one of the few developed jurisdictions with overnight rates above zero.
c. As a result, USD and CAD (vs. rest of currencies in zero rate countries such as SEK, EUR, NOK, etc.) are likely to fall. This in turn can have effects on carry trades out there and their unwind can exacerbate the drop in USD and CAD.
d. Refuge values will continue to be bought: precious metals will continue their rally while longer term US rates (and CAD) would drop lower, increasing the probability of Japanification.
e. Commodities will continue to suffer as global demand will falter.
f. Most importantly, this might be the catalyst for a lot of corporate debt to start coming under pressure. In fact, while sovereign rates will go down, corporation could face difficulty refinancing as their net results will drop. Given the tremendous run higher (in quantity and price) of corporate debt and the wide success of many private debt instruments (alternative fixed income bought to replace low yielding bonds), this corner of the market could be particularly vulnerable albeit in medium-term – once slowdown trickles through results - rather than in short-term.
In this kind of extreme, risk assets will suffer and refuge values will perform while private/corporate debt is likely to suffer strong second effects and USD and CAD are likely to drop versus other currencies.
But fully positioning a portfolio (buy gold & sell USD and CAD, sell equities, etc.) for this extreme outcome would be quite irrational, because if it does not materialize the opportunity cost is high.
The real question is, what positioning would be beneficial in addressing the extreme bad outcome and potentially has a little or low negative impact of all is back to normal?
Like most things in complex systems there is no single answer to this question. It depends a lot on specifics of each investor's portfolio, their goals (performance, horizon, liability, etc.) and risk tolerance. But here are a few hints:
Short USD vs. jurisdictions with zero or negative rates: if US cuts rates then USD will likely fall but if things get better room for rally is limited. In fact, before all of this started USD was making highs against a basket of currencies and it has not particularly come off yet.
Own precious metals: if US cuts rates or risk off continues, their rally is likely to continue. Conversely if all is back to better/normal the downside could be limited (so far since the headlines started mid-January the rally in gold has been about 5%, let’s recall that the goal here is to play an extreme tail, so potential upside in crisis situation can be quite more impressive down a 5% correction.
Lastly derivatives are always an effective risk-management tool, they require expertise and savvy but can deliver very specific outcomes and control risk if used appropriately. (That is one of the things we specialize at LFC and the cornerstone of my approach in 2008)
I will conclude by saying that as a system or group (i.e. the world) we have not witnessed a pandemic in long time (1960s). What lies ahead ss anyone’s. I am neither a virologist or astronomer and really hope that things turn for the better. But being risk-conscious (not risk-averse) is wise and something we might have lost the habit of given the last decade of “fun”. No matter what lies ahead it is important that everyone gives the matter (risk-awareness) some thought.
And finally, for the record, I put the probability of things unravelling to the left (bad outcomes) 25-35% and the right tail (V-shape) 5-10%.
- Kambiz Kazemi
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