March 15, 2020

What has happened in the last three weeks?

The U.S equity market peaked on February 19, 2020, with the Standard & Poor’s Index of 500 stocks (S&P 500) reaching 3,386, and subsequently correcting to 2,480 on March 12, 2020, a 26.75% drop in merely three weeks. Moreover, volatility has been extreme, with circuit breakers (causing a pause in trading) hit twice in the cash market and twice in the futures market in one week.

Here are our observations as to why the market has moved so dramatically:

• COVID-19 is the trigger, and investor sentiment changed quickly from the complacency of viewing the virus as a contained problem in China to fears of a world-wide pandemic. These worries arose from a) uncertainty as to the number of cases and resulting economic and social impact in the U.S; b) the exponentially rising numbers of cases once tests started; and c) lack of coordination and slow actions from various government bodies.
• Prior to the correction, the U.S. equity market valuation was at its historical high (except at the peak of dot-com bubble in the late 1990s) and was relatively higher compared to other regions. COVID-19 in the U.S. has just started, in comparison with other countries and regions. Social distancing as a strategy might impact the U.S more, as it is a service-based economy. Therefore, some correction is justifiable.
• Monetary policy has been extraordinarily accommodative for the last 10 plus years (with a small exception of 2018), which helped financial assets tremendously. However, this monetary policy has unintended consequences, one of which is over-reliance on the U.S. Federal Reserve (Fed). Investors worry that a small misstep could have huge impacts. When the supply chain was broken in China, then in Japan, Korea, and other countries, global payment systems became problematic. Missed payments caused companies to become deficit agents, forcing them to quickly sell securities to raise cash and tap into lines of credit from banks. Since many corporations know that banks have limited cash on hand, many sought to maximize the lines of credit at the same time. Meanwhile, private equity and credit funds also drew on their lines of credit to avoid any potential short-term funding issues. As this cascades, banks become deficit agents. Their liquidity provider is the Fed, largely through the repurchase (“repo”) market. The Fed made an emergency rate cut of 50 basis points (0.5%) with the intention to calm the market, but without fixing the plumbing system, it failed. With big market swings, many financial institutions faced margin calls, as they, too, need to tap into short-term funding. Basically, all these forces caused a modern-day bank run. It was only on March 12 that the Fed addressed the issue by injecting $1.5 trillion into the repo market for two days, and trillions in coming weeks, which is being interpreted by the marketplace as basically unlimited.
• Although the financing system strengthened after the Global Financial Crisis (GFC), with banks amending and improving their balance sheets, the micro-structure (ways markets work day-to-day) of the market changed, as liquidity now becomes scarce during times of need. Dealer inventory is now 10% of the level prior to the GFC, thus impacting their ability to provide liquidity. Instead, the traditional market makers are replaced by high-frequency traders who can pick up retail and institutional flows, but often step back to avoid losing money in periods of extreme market volatility. The increasing impact of Trend Followers (CTAs) and Risk Parity strategies can all accelerate market moves both up and down. In sum, the micro-structure change in the market caused liquidity to dry up when needed.
• The recent oil shock is an exogenous factor that came at an inconvenient time, for markets. OPEC and Russia failed to reach an agreement on March 6, 2020. Saudi Arabia immediately decided to flood the market with oil with a strategy to retake market share. With COVID-19 already dampening oil demand, the Saudi action caused oil prices to drop precipitously. The already-depressed energy sector was bruised further, and many smaller and leveraged players will need to file for bankruptcy, which has a negative impact on the debt financing market. Low oil prices, on the other hand, are a positive to consumers.

What has changed and where are we now?

The Fed corrected its misstep and made extraordinary moves, including cutting interest rates to zero as we write this update. While these moves may have negative long-term consequences, in the near term they are likely to alleviate the short-term funding crisis. The U.S. government seems to be getting its act together finally. The Administration declared a State of Emergency, which gives power to act, and a second stimulus package got passed with more to come. The uncertainty of COVID-19 and questions about the market micro-structure remain, and could cause issues and ongoing market volatility, but it is questionable whether the volatility will continue at the pace we’ve seen in the last three weeks. We remain alert on your behalf as conditions stabilize, especially with more attractive prices for U.S. equity markets.

Dave Klassen, Chief Investment Officer
Lan Cai, Deputy Chief Investment Officer