The Great Lockdown

COVID-19 has annihilated any hope of growth in 2020.

The global economy is in deep trouble.

If you were to pick your favorite economic indicator for any country in the world, it would almost surely be telling you nothing but bad news. Although I imagine there is never a "good" time for a global pandemic to strike, the timing of this one was particularly unfortunate. Coming off of a year riddled with trade tensions, many experts expected growth to inflect higher, driven by ubiquitous central bank stimulus and reduced uncertainty. Then COVID-19 happened. The sheer scope of the damage COVID-19 can cause is insurmountable. Nationwide lockdowns have resulted in widespread unemployment, shocking both demand and supply. The International Labour Organization estimates that workers have lost hundreds of millions of jobs worldwide, and more than 80 percent of the global labor force has been affected by COVID-19. The International Monetary Fund (IMF) didn't mince its words when it announced that "It is very likely that this year, the global economy will experience its worst recession since the Great Depression."

A public health crisis turned into an economic crisis.

The best response to a novel virus, like COVID-19, is to buy time for scientists to develop permanent remedies to the virus. These solutions range from testing kits to vaccinations, all of which have different timelines. Until these solutions are developed, the optimal response is to mitigate the spread of the virus through social distancing and various hygiene measures. For those interested, I've done an entire piece on the public health response in the form of an explainer series here. Unfortunately, these types of policies carry a hefty economic cost. With companies virtually at a standstill, there's a growing concern that businesses will run out of cash to cover any expenses (debt payments and leases, etc.); after all, it's hard to generate operating income if you aren't operating. In short, that means that companies will have to tap banks to get funding. For short periods, banks can provide relief, but eventually, the banks themselves come under pressure. Regulations force banks to maintain a certain amount of reserves and slowly remove themselves from the lending market. That's where things start to get dicey. What was a short-term cashflow problem morphs into a question on a company's long-term solvency. The threat of disruption to these cash flows can trigger a chain reaction of insolvency with the potential to create permanent damage to the underlying economy (companies basically disappear). Unfortunately, it is something that many in tune with the situation have known and indeed warned about for years. The sheer size of the population that lives one missed paycheque away from some form of insolvency is unsustainable.

A self-induced coma.

The unprecedented collapse in growth isn't like a "normal" recession. Yes, this crisis has exposed many underlying problems in the economy. However, those problems on their own didn't trigger a recession; policymakers did when they ordered a global lockdown. I think that's an important distinction when evaluating the remarkable response from both central banks and politicians. Central banks have put forth a myriad of policies to support market functioning in obscure corners of the market. The argument there, as specified by the Bank of Canada governor, is that you would never complain to a firefighter for using too much water to put out your house fire. That is akin to central banks, who have gone above and beyond expectations to keep markets stable and liquidity ample. On the fiscal side, it seems like some of the bipartisan tensions that were present in the first funding package have started to subside, at least on the surface, and aid packages are being passed relatively quickly. That on its own is good news and may well mark a shift to a multi-tiered response of coordinated fiscal and monetary policy in the future. Below is a figure from UBS that breaks down the budgetary response in 2020 relative to 2009.

Source: UBS & Heisenberg Report

Despite the dire outlook, markets have stabilized.

From defcon 1 to defcon 3.

It is now pretty clear that the worst-case scenario for the first "wave" of infections isn't going to play out in most countries. That is not to suggest that this hasn't been a human tragedy; it just means that relative to what models were projecting, things are marginally better. Markets are responding to the hope that economies around the world will gradually reopen; however, the sustainability of that prospect is precarious at best. The lack of widespread testing makes the prospect of a second "wave" of infections later this year almost an inevitability. Again, I recommend readers take a look at the explainer series on COVID-19 for more details on this.

The market is looking to through Q2.

Of course, the economy cannot remain dormant forever, and market participants are trying to look through the damages of COVID-19 on the hopes that they are temporary. There are obvious problems with that assessment. There may be a great rationale behind closing the economy, but that doesn't make the 200 million people that are unemployed globally any less unemployed. As one analyst put it, stripped of all nuance, buying stocks because the underlying economy is sound when it's open is like paying the medical bills of a person who is in a coma due to a freak accident. Even if doctors project that the coma won't be permanent, hoping the patient will pay you back with interest once they wake up is a dicey investment at best and flat out stupid at worst. The fact that analysts are suggesting that economic activity itself is not a reflection of fundamentals is absurd. In the example above, it's like saying the guy being in a coma has no impact on his ability to pay me back. There is also the paradox that reopening the economy won't fix the behavioral damage from COVID-19. If all businesses were open tomorrow, I don't think you would go to the mall and "shop till you drop." I am not going to go to Starbucks and buy 40 coffees to make up for the month and a half I've spent in quarantine. I'm also not convinced people are going to go to restaurants or fly in confined metal tubes in the sky until we can be guaranteed our safety. As Deutsche Bank's Kocic puts it, "when precarity becomes everyone’s prospect, the consumers from a wider sector of the population withdraw and the rest of the economy gradually has to contract or shut down."

Central banks have worked hard to reduce the risk of a market crash.

In the credit markets, the Fed's actions have convinced some investors that the market will live to fight another day after speculation of imminent collapse from several accredited investors (Ray Dalio being one of them). Central banks have increased the scope of their asset purchases from government bonds to now corporate investment-grade and high-yield ETFs. The latest string of policies touch on the "unofficial" mandate of central banks, which is to supply convexity/stability and promote market functioning. As expected, these policies have been met with much scrutiny as there exists plenty of moral hazard in having central banks purchase high-yield debt products. That aside, these policies are a stabilizing force in markets because they crowd out investment in government bond markets and create artificial demand for corporates. Indeed that's part of the reason we've seen markets rebound in the last few weeks. Central banks have put a floor on asset prices and have reduced the probability of a market crash. We are starting to see that show up in quantitative risk models that calculate the max expected loss. The chart below shows the Value-at-Risk (VaR) estimated from a GARCH (Generalized Auto Regressive Conditional Heteroskedasticity) model on the S&P500. The black line indicates the 5th percentile of expected returns on each day. Any return daily below that cut off is marked red and is considered a "tail event." That 5th percentile is starting to get dragged higher, indicating a tighter trading distribution for returns.

Volatility lingers like stale cigarette smoke.

I know it may not seem like, but things are slowly creeping back to normal. I know it's common to see a 3 percent swing in US equities within the trading day, but that is a far cry away from the 10 percent swings that were whipsawing your portfolios a few weeks ago. The problem is that, like stale cigarette smoke, volatility lingers. Central banks supply convexity and stability through asset purchases and interest rate cuts, which lowers interest rate volatility but pushes uncertainty elsewhere. That's mostly due to questions surrounding the effectiveness of the policy itself. The chart below shows the above in real-time. We can see that the ratio of interest rate volatility to equity volatility plunged to a record low over the last few weeks. The fact that volatility has lingered for so long has mostly kept the systematic community out of the market.

Dealers are starting to get long gamma again.

Although systematic flows have remained muted, if volatility continued to normalize, we should expect these funds to begin to deploy capital. What's particularly noteworthy is the volatility of volatility (VVIX Index), which has continued to bleed over the last few weeks, hitting levels seen in early March. This type of movement indicates that the market is beginning to reprice large market moves, a similar story to the one painted above using the VaR model. Throughout March, option premiums were through the roof, making it very appealing for market participants to be net sellers of options (particularly calls). As such, market makers will be increasingly net buyers of stock futures as volatility continued to drift lower (dealers are long gamma in this trade). Dealers are also net long gamma now, meaning that their hedging flows will be acting as a shock absorber in markets. The chart below shows how gamma is related to daily returns in the S&P500. We can see that when we cross the red line (negative gamma), markets become more volatile.

I'll write an explainer series on these dynamics in the coming weeks. The bottom line, for now, is that these flows will act as a damper in the market and should continue to drag realized volatility lower. Remember, the lower realized vol goes, the more systematic funds will be drawn back into the market. The chart below shows the estimated positioning of daily volatility control funds. We can see that the 1-month window is starting to increase exposure, potentially signalling a turning point in the market. What's important to note is that these types of flows will happen irrespective of fundamentals, meaning that markets could go back to all-time highs before the end of the summer if conditions are right. Of course, we also face the prospect of the falling corporate bid as share buybacks are expected to fall to around half of what they were in 2019, the lowest in the last five years, and a net negative for equities.

A world post-COVID-19 will look very different.

There will be scars.

Despite the government's best efforts, some companies won't make it out of this. That will cause permanent damage. Just in the US, Wells Fargo, JPM, Citi, and Bank of America combined are allocating US$ 24 billion to credit losses based on their Q1 earnings reports. Let's not lose track of the fact that, assuming these estimates are realized, these are households and companies that are losing everything. That entails real damage and does takes time to heal. There is also an enormous potential for a widespread cut in wages and salaries, which will cause permanent damage to consumer spending.

Is COVID-19 inflationary or deflationary?

Inflation in developed economies parallels something of a lost legend. What was once roaring throughout the 1970s, inflation has been "tamed" through fundamental changes to policies and the broader economy. However, with COVID-19, some economists have begun to fret that inflation may once again rear its ugly head. In the simplest terms, price inflation is a result of "too much money chasing too few goods." At the heart of the debate is the disruption to global value chains, which have halted production to contain the spread of the virus. With production choked out, many have raised concerns that some products may be in short supply. These supplies need not be medical gear. Believe it or not, a Smithfield pork processing plant in South Dakota (SD) is playing a critical role in pushing this narrative. Smithfield's CEO, Ken Sullivan, said last week that shutdowns across the country are pushing the country perilously close to the edge in terms of our meat supply. There's an excellent Bloomberg article that summarises Sullivan's concerns; however, there has to be some embedded irony in the fact that people are dying at slaughterhouses. Of course, the other side of the aisle says that as people lose their jobs, the demand for goods falls in general. That has the potential to be offset by the massive stimulus programs governments are implementing to support workers and firms who have been impaired by the pandemic, and that's where the "too much money" side of inflation comes in. Whatever it may be, inflationary effects will likely start to appear once the virus is no longer a concern.

Tiago Figueiredo