The global spread of the pandemic and stock market crash have occupied the planetary scene in recent weeks but, in the background, other phenomena have started, leading to changes in monetary policies and therefore, in the way of managing money, which could mark an epochal turning point.
The adoption by the central banks in the west of measures inspired by the Modern Monetary Theory (MMT) has had a sudden acceleration. In a world that, in the near future, will likely be characterized by low growth and low-interest rates, this will favour companies with high innovation capacity, capable of creating above-average growth and cash flow regardless of the trend in GDP. The cash flows, discounted for artificially low rates, will determine the success of subjects such as Facebook, Apple, Netflix, Google (i FANG), Microsoft and their new competitors, assuming they emerge.
Let's take a closer look at what has happened in the last few weeks away from the spotlight and why we come to this conclusion.
In these days most of the (many) managers with portfolios built for "all seasons" have found themselves in the need to apply the principle of risk parity which provides for the division of the portfolio according to (also) the volatility of the individual investments: hence the sudden necessity of liquidating a large portion of any asset class to decrease volatility.
This magnitude of this action trend has reversed the inverse correlation between equities and government bonds. When the ones usually go up, the others go down and vice versa, which, historically, has always allowed building balanced strategies. The generalized sale of all asset classes by funds managed according to the principle of risk parity (but not only) led to a drop in the prices of all asset classes (shares, high or low-quality corporate bonds, government securities, with high and low ratings, gold and, for other reasons, oil). Considering the size of the assets under management, a vicious circle has been triggered which has added to the liquidity crisis of the US Treasury securities markets (in place since last September and described in previous newsletters) and to the fear, founded, of a blockade of the global economy.
The contemporaneity of these three phenomena (and the still vivid memory of what happened in 2008) has led governments and central banks to take unprecedented measures to support businesses, banks and families. Central banks, in particular, have announced liquidity injections, infinite (FED) or very high (ECB), and the purchase of bonds (government and corporate) to avoid the risk that the absence of buyers will generate further sales.
These actions, combined with those to contain the spread of the virus, have calmed the markets, promptly rallying by a few points, but this rebound must not be deceiving. Analysis of past crises indicates that, in 70% of cases in which the market has reversed more than 30% (as happened this year), new lows were then tested. And when the reversal was followed by a severe global recession (it remains to be assessed whether the global recession will be severe or moderate) the decline continued for a few months.
Let's now see how the action of the central banks could bring about an epochal change in the orthodox monetary policies followed so far and, therefore, in the way of managing and selecting investments.
The new neo-Kenyan paradigm
MMT (https://en.wikipedia.org/wiki/Modern_Monetary_Theory), a kind of Keynesian theory on steroids, theorises (among other things) that governments and central banks direct the economy towards full employment through fiscal policy and the creation of new money supply. The much-contested theory made many proselytes after the 2008 crisis when central banks found themselves having to provide liquidity to the banking and economic system.
In the last few days, the Fed and then the ECB have waded the Rubicon by pushing decisively into the territory of the massive doses of liquidity and even direct financing to the economy. Interventions that, by quantity, could even exceed those of governments. It is estimated, for example, that the budget of the FED (now reached around four trillion dollars following the securities purchased over the years) can reach ten trillion thus putting an end to hopes of tapering and normalization of monetary policies advanced in times recent.
Among the possible implications of the escalation in the interventions of the American central bank, one should make investors (institutional and private) think: the combination of monetary and fiscal policies could determine, in the long term, the end of the ten-year Treasury rally (which began in 1981). In the short term, however, it could go differently, given that GDP and government bond yields are still correlated and, therefore, a fall in the former could lead to a new rally for the latter.
The permanent vitality, within the framework outlined, of two deflationary trends (population ageing and technological innovation) will not divert the American central bank from the rigid control of interest rates to keep them aligned with the yield curve. Which, in the long term, will lead the risk/return ratio in an area without attractiveness for investors.
Another likely consequence that investors will have to bear in mind is the long-term orientation of monetary policies. The enormous pressure from Western governments has accelerated the introduction of MMT in recent days, but if the virus, as it is reasonable to believe, will be a temporary phenomenon, these policies are likely to last: history teaches it.
The effects of debt monetization
A de facto monetization of the debt of this entity has only two precedents in the past (in June 1920 and in March 1947, in the aftermath of the world wars) and, in both cases, it caused double-digit inflation due to the increased circulation speed of the currency.
The first derivative of this phenomenon is that the inverse correlation between equities and government bonds will disappear, or will diminish, with all due respect to the balanced management managed by the principle of risk parity.
If in this scenario, it is decided to reduce the risk by selling shares and bonds, because the only temporarily safe asset is the cash, this can significantly change the management policies.
First of all, we could stop buying the government bonds of the countries in which central banks intervene by manipulating the yield and keeping rates will remain artificially low because there is no possibility of performance. This would lead us to look towards securities from the eastern area (China, Singapore, Indonesia or India).
Even more interesting, the implications for the stock market. In a scenario of rates kept low by central banks, equities will perform relatively better with the likely exception of sectors facing nationalization (as happened to banks after 2008), starting with airlines, where we will probably see a levelling between operators and where the various low-cost airlines will lose competitive advantages and attractiveness. Nationalization will inevitably place limits on management, with a ban on buybacks or a reduction in the distribution of dividends. The same will probably happen for oil companies.
The preference should go to those who will be able to demonstrate growth independently of the evolution of GDP: a cash flow that grows more than GDP can be discounted at an artificially low rate, creating value and increasing stock market prices. To date, generalizing, companies of this type have been listed on the Nasdaq. Facebook, Apple, Netflix and Google (FANG), to which Microsoft is likely to be added, are, in this light, the favourites.
Finally, gold. In recent weeks the volatility has been very high: it was first sold massively (a bit by risk parity managers but above all by hedge funds, called to cover the margin calls on Treasury arbitrage), then bought after the announcement of the expansionary manoeuvre of the Fed. The price of gold has a historic upward limit of 1,921 USD / oz, established in 2011 when it seemed that the G7 banks were losing control of the national debt crisis (a crisis that, in 2012, led to the famous "whatever it takes ” by Mario Draghi that definitely reassured everybody). It is unlikely that, in the short term, the G7 central banks will accept to review those levels, but we remain convinced that there are reasons to have gold in the portfolio and that, more orthodox central banks, they will always be interested in buying. In the short term, gold seems to have lost its momentum though. We will take it up again when we are more convinced that a rush to the checkout by large investors in troubled waters is no longer necessary.
In conclusion, and returning to the short term, we would be amazed if, waiting to understand the extent of the possible global recession, the S&P 500 did not retest the minimum levels just reached a few days ago (2,200).
Simplify Partners Management Team