A black swan on the financial markets

The people of the world are currently going through a devastating public health crisis. Meanwhile, actors on the financial markets are facing a proverbial “black swan”. The dizzying plunge in equity prices in recent weeks is nigh-unprecedented in the last hundred years of stock-market history. We see two possible scenarios for the further course of this year: a “speedy convalescence” or a “viral depression”.

Quickest bear market of all times

The expression “black swan” is on everyone’s lips these days. And rightly so, because what we’re experiencing right now – a highly improbable incident with tremendous impacts on (world) events – is exactly what the Lebanese-American philosopher Nassim Nicolas Taleb described in his book bearing precisely that same title. “Black swans” appear entirely unexpectedly and are usually not foreseen even by experts; they are difficult to foretell from an analysis of history.

The coronavirus pandemic isn’t the only “black swan”; so is the performance of the financial markets in recent weeks. From its all-time high on February 19, the US equity market, as measured by the S&P 500 Index, tumbled into a bear market – i.e. lost more than 20% of its value – in the span of just 16 trading sessions. The drawdown to the low point so far hit at the start of this week has since stretched to 30% in the meantime. Almost every stock index around the world has been hammered to a similar or even worse extent. A selloff of this speed and magnitude is unprecedented in the annals of stock-market history. Even the great market crashes of 1929 and 1987 have been eclipsed by the declines in recent days.

Unprecedented
Quickest bear market of all times

Historical bear markets (drawdowns greater than 20%) in S&P 500 Index

The global financial crisis, which was likewise a once-in-a-century event in its own right, also hardly serves as a blueprint. Over the past month, the S&P 500 Index has registered daily fluctuations of more than +/– 4% on six consecutive days and whipsaw swings exceeding +/– 9% on three straight days during that span. As a result, the US volatility index (VIX) has spiked to 85 points at last look, surpassing even the sky-high level recorded in autumn 2008 at the apex of the financial crisis.

Record-high volatility
Higher than during the financial crisis

Volatility index (VIX)

Liquidity drying up…

What explains these unprecedented movements on the equity markets? Even though we’re still in the middle of the crisis, some conjectures can already be ventured today. The sheer speed with which the coronavirus has spread around the world in mere weeks is certainly one key aspect. This means that in possibly record-breaking time, economic activity throughout large swaths of the world has slowed or will decelerate severely and corporate earnings will plummet. As of today, a technical recession (two consecutive quarters of negative economic growth) and a double-digit earnings contraction at the least are a foregone conclusion even in the best-case scenario. A month ago, such a development had been almost inconceivable, so there’s an accordingly huge shock that the financial markets now have to digest.

Moreover, the ever-growing presence of systematic trading strategies such as trend-following CTA funds and volatility-based risk parity funds is reinforcing the dynamics of the downward move. Such investment vehicles must often reduce their positions precisely when prices drop below certain levels or when volatility increases, which puts added downward pressure on prices. High-frequency or algorithmic traders also play an ominous role because when the stress level on the financial markets climbs too high, these market participants simply turn off their “machines”, causing liquidity on the market to dry up. This has been observable in plain sight in recent days: the bid-ask spread has widened considerably even for blue-chip stocks. The market volume on futures exchanges has shrunk so dramatically in some instances that for S&P 500 futures, the liquidity offered per price level has decreased in some cases to just one-fiftieth of the usual liquidity. Opportunistic buyers, which can act as counterweight in such a market, are in scarce supply these days. The proprietary trading desks of banks on Wall Street, which used to play this kind of role in the past, were forced to almost completely shut down their operations in the aftermath of the financial crisis.

…positions being liquidated

The current stock-market crash even caught many market pros on the wrong foot. There are mounting reports of hedge funds, for example, that have suffered enormous losses in recent weeks. Reports of colossal mis-positionings or mis-speculations and bankruptcies here and there will also be heard in the weeks ahead. The gold market, for example, provides evidence that there were some forced liquidations recently as market participants exceeded risk limits. The yellow precious metal was sold to raise urgently needed cash, and its price was intermittently down 15% from its high two weeks ago.

The plunge in stock prices has also left its marks on investor sentiment.

Shakeout well advanced, also with regard to sentiment

In the meantime, however, the unwinding of risk holdings and large equity positions by systematic investors is probably well advanced by now. According to the latest data, CTAs are actually even positioned short at present, which means they are betting that prices will fall farther. Selling pressure from this side therefore looks set to diminish going forward. And the plunge in stock prices has also left its marks on investor sentiment. The very high put-call ratios on options exchanges indicate that investors are hedging heavily out of a fear of further losses. Furthermore, Bank of America’s latest survey of fund managers revealed that they have massively reduced their equity positions compared to the prior month.

Two possible scenarios

Against this backdrop, a foundation appears to be in place for prices to start bottoming soon. In the wake of a 30% nosedive over the span of a few weeks that has knocked stock prices in some cases back to their 2016 levels, the risk/reward tradeoff for the months ahead looks balanced to mildly favorable. Investors should therefore exercise discipline and not let themselves be infected by the potential panic that might be evoked by the extensive shutdown of public life.

Back to square one
Equity markets give back multi-year gains

MSCI USA and MSCI World ex-USA indices

For the course of a possible rebound and the time thereafter, two main scenarios are conceivable. In the positive scenario (“speedy convalescence”), in which the restrictive measures that have been implemented by countries lead to a rapid flattening of the number of new infections, the sharp contraction in world economic growth remains limited to the first half of 2020. Only the first two quarters would show negative growth rates. They would be followed by a rapid recovery that would bring world GDP growth for the full year to approximately +1%. Although a “technical recession” of that kind would be severer than the one in 2001, it would not be nearly as devastating as the one that occurred during the financial crisis in 2008/2009. Equity markets under this “temporary shock” scenario would recover comparatively quickly, like they did after the “Black Monday” market crash in 1987.

Under the second scenario (“viral depression”), in contrast, the world fails to devise and implement an adequate response to the threat posed by the coronavirus. Quarantine measures to contain the spread of the virus and the fiscal policy response from policymakers both prove insufficient. Monetary policy reaches the limits of what it can do and is now only able to smooth out frictions on the financial markets. But only radical packages of economic policy measures (in the size of 2% to 3% of GDP) are capable of mitigating or actually averting hazardous second-round effects that loom as a result of the public health crisis. Without support from fiscal policy, economic activity under this negative scenario would remain paralyzed in a state of shock until far beyond the summer, and the depth of the global recession would be similar to what was experienced in 2008/2009. The world economy would face a contraction of around 1% for 2020. As for market performance, a temporary rebound in stock prices would ultimately prove to be just a bear market rally, i.e. a respite before the next downwave.

Hoping for a “speedy convalescence”
Two possible scenarios

Annual global GDP growth

We will continue to keep a watchful eye on developments in the weeks ahead and will regularly reassess the probabilities of the different scenarios. It appears certain, though, that volatility on the financial markets will stay high for the time being. The economic “damage” for market participants probably won’t become fully apparent until the number of new infections has crested in developed economies and later in the USA (due to the delayed spread of contagion there), and only then are investors likely turn their sights back to the future. For our portfolios, we, as always, will appropriately weigh the risks and rewards in the weeks ahead and will stick with our sustainable investment strategy aimed at long-term asset growth.