Q1 2020: “Managing Short Exposure in an Unprecedented Environment”
First of all, I hope everyone has been staying healthy and safe. In January’s call, I recall saying, “Let’s hope this new coronavirus proves to be no big deal.” Regrettably, it became so much of a bigger deal than any of us could have imagined. Those of us on today’s call are surely the fortunate ones.
Last year was a period of extraordinary policy developments: despite stocks at all-time highs and unemployment at 60-year lows, the Fed employed aggressive monetary stimulus measures – cutting rates and restarting QE. Moving early and aggressively – so called “insurance” policy measures became the Fed’s prescribed policy approach.
So, to begin 2020, as a manager of short exposure committed to a lower-risk approach, I confronted the challenge of managing accounts that had already suffered losses – with a Federal Reserve poised to respond forcefully to incipient market instability. This played heavily in my risk vs. reward calculus.
Despite my view that we were nearing the end of history’s greatest bubble, our investment philosophy, risk disciplines and macro analysis were in alignment – dictating that short exposure be managed carefully.
Here’s what’s important to understand: most short funds rebalance everyday – that means they adjusts short exposure to ensure they starts each new trading session at 100% short. This aspect of managing short exposure tends to be confusing: Unlike on the long side, short exposure and account value move in opposite directions. For example, if short exposure is at 100% of account equity (let’s say a $100,000 account with $100,000 short exposure), a 1% decline in the market index would see short exposure decline 1% to $99,000, while account equity would gain 1% to $101,000. Rebalancing means adjusting short exposure to get back to 100% short. In a market decline, this means repeatedly increasing short exposure to stay 100% short to keep up with gains in account value.
So, in a downward-trending market, this works to somewhat compound returns. In a simple example, think in terms of a market down 10% - with an index short fund up 10% year-to-date. If the S&P500 then falls 1% (for an index at 90% of its beginning year value), the S&P500’s year-to-date loss would then be 10.9%. Meanwhile, the index fund’s 1% gain would be on a bigger base (110% of where it began the year) – increasing y-t-d gains to 11.1%.
Things get trickier after an index suffers a major decline. Imagine a market index that begins the year at 100 – and then falls 20%. In our simple example, the index would drop to 80 and our hypothetical bear index fund’s value – starting the year at 100 – jumps to 120 after profiting 20% from the market decline (this example ignores compounding). But now let’s say the market reverses abruptly and rallies a quick 20%. So the market index would rise 20% off its 80 level – jumping to 96. Our hypothetical bear index fund – suffering a 20% decline from its 120 level – loses $24 – dropping down to 96. In this simple example, the index then has a 4% decline, with the hypothetical bear index fund posting a 4% loss – as major volatility had the fund failing to benefit from the y-t-d market decline.
As much as it would have been rewarding to have had more short exposure – and some more volatile higher “beta” shorts - that comes with greater risk of performance issues. During the crisis period in 2008, the SEC announced a ban on shorting key financial institutions. My financial stock short portfolio rallied 10% in one session – in extreme volatility I had not experienced in my almost 19 years of shorting at that time. We’ll, 2008 now seems rather placid compared to this year’s crazy market swings.
In 13 sessions starting on March 3rd, the S&P500 collapsed 28%. But we’ve experienced some extreme upside volatility as well. From March 23rd lows to the March 26th close, the S&P500 rallied 20%. The Russell 2000 small caps had two 20% plus rallies – between March 23rd and 27th – and then from April 3rd to the 9th. The Bank index had rallies of 25% and 28%. The Goldman Sachs most short index posted two 30% rallies.
Many of the higher volatility strategies have really suffered during this rally. “Bear market” rallies tend to be the most ferocious. And such upside dislocations force difficult decisions on the short side. Do you cut back exposure on price spikes, which can really negatively impact performance? Or do you let positions run against you and watch overall short exposure expand rapidly? Importantly, the higher the portfolio beta the more consequential these trading decisions become. Wrong guesses can be quite painful.
Expectations for extreme uncertainty and market volatility have played a decisive role in my decision to run short exposure within very well-defined parameters. As I said earlier, it’s not very satisfying – but it means we get through this unprecedented period without big negative surprises.
I would have expected to have added more short exposure during the decline – but I held back because of my long-held rule of adopting a cautious approach when the Fed commences crisis management measures. Recall that the Fed cut rates on March 3rd after an unscheduled emergency meeting. The next week the Fed boosted the potential size of repo operations by as much as $500bn, and then slashed rates to zero and announced a $700bn QE operation on Sunday, March 15th. Boosting short exposure after a QE announcement is a risky proposition.
The Fed then began creating various emergency funding facilities – starting with programs from 2008 that offered liquidity support to banks, broker/dealers, commercial paper, and the money markets – and then introduced new facilities for state & local governments and “main street.” The Fed announced it would purchase investment-grade corporate bonds and ETF shares – later broadening this mandate to include recently downgraded junk bonds as well as ETFs that hold high-yield debt. This unprecedented crisis management response saw the Fed’s balance sheet expand a stunning $2.1 TN in six weeks to surpass $6 TN for the first time.
For a while now, I’ve been saying that the Fed’s balance sheet would inflate to $10 TN during the next crisis. There was no doubt that unprecedented speculative leverage had accumulated over this protracted cycle. And as we witnessed during March’s dislocation, in a serious de-risking/deleveraging episode it’s basically only the Fed and central bank community with the capacity to accommodate speculative deleveraging. What’s stunning is how quickly the Fed had to resort to unprecedented monetization efforts. And if Fed asset growth now averages about $200bn weekly – which would not surprise me – the Fed will hit this $10 TN bogey by year-end. It’s incredible – and it’s frightening.
To go along with unprecedented monetary stimulus, Washington has unleashed unparalleled fiscal stimulus with estimates for this year’s federal deficit approaching $4.0 TN. I fear we’ve entered a precarious phase of unbridled monetary and fiscal stimulus that will be quite difficult to rein.
I want to address what I fear is a momentous misconception. The conventional view holds that the U.S. economy was healthy and robust prior to the outbreak. With some temporary pandemic-period support, the U.S. will rather quickly return to its previous enviable position – most believe.
Here my analysis takes strong exception with this popular view: U.S. financial and economic systems had for years been dominated by bubble dynamics, part of historic global credit and speculative bubbles. Unprecedented speculative leverage accumulated over this long cycle throughout securities and derivatives markets - at home and abroad. Years of ultra-loose finance also imparted deep structural economic maladjustment. More specifically, scores – I would say thousands upon thousands - of uneconomic small, mid-sized and large enterprises proliferated in a backdrop of booming finance and inflating asset prices.
Years of the “easiest money” imaginable created an unsound system dependent upon rapid credit growth, rising financial leverage and asset inflation. So long as the boom continued, the system appeared robust despite worsening latent fragilities. The system appeared sound and bulletproof as of February 19th. But in March we witnessed how abruptly a “risk on” backdrop can transform into “risk off” deleveraging, illiquidity, dislocation - and crisis.
I believe COVID-19 is the catalyst for piercing history’s greatest global bubble. When I refer to a bubble, I am speaking of a self-reinforcing but unsustainable inflation – generally fueled by credit and speculative excess – and typically underpinned by government intervention and resulting market dysfunction. I have argued that unprecedented post-mortgage finance bubble reflationary measures – notably extreme monetary stimulation and government debt growth – unleashed what I have referred to as the “global government finance bubble.”
I have called this the granddaddy of all bubbles, believing there is no fledgling bubble ready to reflate the global system when the current bubble deflates. From a bubble perspective, we’ve reached the end of the line. There is no source of credit to massively expand beyond central bank credit and government debt. There’s no grander economic bubble to inflate when the bursting of China’s bubble takes down EM and myriad global bubbles in the process.
I am confident in the bursting bubble thesis, with global policymakers now desperately expanding central bank liquidity, government borrowing and spending, along with the most egregious market interventions – all to try to hold bubble collapse at bay.
This comes with great risk – with policymakers literally risking a crisis of confidence in central banking, in the financial markets and for finance more generally.
Let’s delve deeper into our macro analysis, first with a global focus and then circling back to the U.S. Today, we see three critical international fault-lines – Europe, the emerging markets and China - that are key areas of fragility made acute by the pandemic. First, there’s Europe – with its structurally weak economies, fragile banking systems, social and political instability, and vulnerable euro currency regime.
In particular, Europe’s troubled periphery has been hit hard by COVID-19. Spain and Italy trail only the U.S. in global infections. European ministers met again today in an attempt to cobble together some type of agreement for an EU COVID stimulus package. Italy came into this crisis with national debt to GDP approaching 140%. In a likely scenario where GDP contracts 10% - and with debt surging at least 20% this year and growing rapidly again next year – it’s not long before Italy is facing an unmanageable 200% of GDP debt load.
Conservative estimates have Portugal government debt expanding to 146% of GDP this year and Greece to 219%. Italy’s weak coalition government is arguing for the EU to issue systemwide “coronabonds,” then employing these funds for grants to troubled nations. Germany, the Netherlands and others have been adamantly opposed to debt mutualization. The Conti government is warning EU officials that Italy cannot handle a surge in debt issuance - and will not put its citizens through Greek-style austerity and debt restructuring.
My view is that Germans and Italians sharing a common currency is unsustainable over the longer-term. I have expected hardship that would accompany the piercing of the global Bubble to again place European monetary integration at risk. Italy’s deteriorating circumstance risks sparking public support for exiting the euro.
An important facet of March’s global dislocation was the spike in Italian bond yields – along with a dramatic widening of European periphery yields versus safe haven German bunds. I believe the global leveraged speculating community is a major holder of Italian and periphery bonds – ensuring vulnerability to “risk off” illiquidity dynamics.
And a euro breaking lower on heightened concerns for periphery debt and euro zone integration would only add fuel to the dollar’s upside dislocation. With king dollar already benefiting from the U.S.’s competitive advantage in fiscal and monetary stimulus, an additional push from a euro crisis would place only more pressure on faltering EM currencies – including the renminbi.
Let’s shift to the Emerging Markets: I believe EM booms have been a central facet of the global bubble, thriving from a confluence of overheated domestic credit systems and booming Chinese demand and credit excess, along with unparalleled leveraged speculation and international inflows
I remember when “developing” economies were called “Roach Motels.” International speculative flows would gravitate freely into EM booms, only to eventually be trapped by collapsing currencies, illiquidity and capital controls – come the arrival of the bust. After the most protracted of booms, I believe a historic bust has commenced.
Collapsing EM currency and bond prices were a key aspect of March’s “seizing up” of global markets. Central bank policy measures – including the Fed’s expanded international swap arrangements – along with the global rally have somewhat stabilized “developing” markets. Yet EM remains the global financial system’s weak link. EM has added unprecedented amounts of debt during this long cycle, too much dollar-denominated. Widespread debt restructurings and defaults seem unavoidable.
EM now faces a very difficult road ahead. “Hot money” outflows have commenced, currencies have faltered, and bond markets have turned unstable. Acute financial and economic fragilities have begun to surface. Importantly, EM central banks lack the flexibility to employ monetary stimulus to the extent enjoyed by the major central banks. Liquidity injections risk exacerbating outflows and currency crises, at the same time stoking inflationary pressures and bond yields. Sinking EM currencies and bond prices then incite panicked “hot money” outflows, dislocation and financial crisis.
To make a bad situation worse, aggressive stimulus by the Fed bolsters U.S. Treasuries and securities markets, drawing international flows to king dollar. The stronger dollar then further pressures EM currencies and stokes de-risking/deleveraging dynamics.
I believe EM has entered what I expect will be a deep multiyear downcycle, with far-reaching market, financial, economic, social and geopolitical ramifications. Emerging market economies, certainly including China, played a powerful role as the “global locomotive” pulling the world out of the previous crisis period. They will now act as a major drag.
I worry greatly about a potential collapse of China’s historic credit and economic bubbles. Keep in mind that China’s banking system expanded more than five-fold - from about $8 TN to $42 TN in dollar terms – over this cycle. Such excess virtually ensures deep systemic structural maladjustment. It certainly fueled a historic apartment bubble. Housing and economic busts will leave one colossal hole in Chinese bank capital. And I know complacency is rooted in confidence that Beijing has everything well under control – that they will simply recapitalize their banking system using central bank – PBOC - credit.
As for the economy, China’s GDP contracted at a 9.8% pace during Q1. But despite the slowdown, China’s dangerous “terminal phase” of credit bubble excess runs unabated. Quarterly growth in China’s Aggregate Financing metric – the key measure of system credit expansion – jumped to a record $1.574 TN during Q1 – 29% above Q1 2019 growth. I fear for what the unfolding downturn will reveal about Chinese finance.
I believe COVID-19 will prove the catalyst for piercing China’s historic bubble. Chinese consumer confidence was inflated by years of rising incomes and apartment prices. China now confronts its first housing downcycle, with an estimated 60 million unoccupied units. With expectations now deflated, it might be some time before consumer spending returns to pre-virus levels.
Already struggling with huge overcapacity, China’s massive export sector faces the grim prospect of collapsing EM demand and global depression. In a recent CBB, I referred to China as the “king of subprime.” Not only did China develop into the manufacturer for the world, it was also the leading financier for scores of emerging market economies. Beijing now faces the difficult choice of “throwing good money after bad” or “cutting bait.” This aspiring superpower will not easily pull back.
Beijing and the People’s Bank of China also face tough decisions with regard to fiscal and monetary stimulus. To hold collapse of their maladjusted system at bay will require massive U.S.-style stimulus. Such measures, however, risk a crisis of confidence and a highly destabilizing run on the Chinese currency. I believe a disorderly fall in the renminbi poses major global systemic risk.
We’ll wrap up this segment with focus here at home. Let’s return to conventional thinking that the U.S. economic boom was fundamentally sound - versus my view that our market and economy were an unsustainable bubble fueled by years of loose finance, including last year’s aggressive monetary stimulus and fiscal deficit.
This is no mere intellectual debate. These are two competing analytical frameworks, and it matters tremendously which one proves closer to reality. If the bubble analysis is accurate, expect the real economy to require massive ongoing stimulus. Anticipate fragile financial markets demanding unending Federal Reserve stimulus.
Looking back to the previous crisis, Continuing Claims for Unemployment nearly doubled to four million from the initial subprime eruption in June 2007 to the heart of the crisis in late-2008. The unemployment rate had jumped from 4.5% to 6.5% prior to the Fed unleashing a trillion dollars of QE. It was a terrible hardship for millions of workers. Yet scores of uneconomic businesses that proliferated during the “loose money” boom had to be shuttered. Resources needed to be reallocated, with the system requiring a period of major adjustment and restructuring.
Clearly, over the past month central bankers and government policymakers were not going to allow markets and economies to collapse. But our runaway financial free-for-all will come with steep costs.
A decade of ultra-loose monetary policy ensured unprecedented proliferation of uneconomic enterprises – from sole proprietorships to small business to major corporations. Many of these businesses are viable only with boomtime conditions. There has similarly been a proliferation of businesses that depend on loose financial conditions and rising securities and real estate prices.
A dangerous view took hold that central bankers had conquered the business cycle. “Whatever it takes” central banking would resolve any problem – no longer did we need to fret bear markets or recessions, not to speak of crises. Such perceptions became deeply embedded in financial asset prices. And this epic loosening of financial conditions sowed the seeds of what I expect to be the most challenging downturn since the Great Depression.
I didn’t believe it in the past and I definitely don’t believe it today: More central bank “money” and market intervention is not the solution. Inflationism is instead fundamental to the problem.
What gives me confidence to claim the bubble has been pierced? First of all, I believe confidence in central banking has been badly shaken. We’re now in the second major financial crisis in 12 years. It will not be so easy to dismiss this episode as the “100-year flood.” It’s been a global bubble dynamic, and confidence in policymaking is taking a decisive hit worldwide. I expect faith that “Beijing has everything under control” to be challenged. Markets will likely begin questioning the soundness of international financial structure.
Markets have over this cycle made assumptions with regard to market liquidity and continuity. We’ve recently seen some of the biggest market swings in decades – even generations. We saw the VIX index surge from 14 to 84 in about three weeks. Markets experienced systemic illiquidity across the board – including Treasuries. Corporate bond ETFs rapidly lost 20% of their value. This week we witnessed the front month WTI crude contract sink 300% in one session to negative $40. We’ve witnessed things that couldn’t happen – actually happen.
We now live in an age of alarming uncertainty. Myriad latent risks have sprung loose – and I don’t believe they will be contained by central banks or global policymakers. This ensures a momentous change in market risk perceptions. At this point, I doubt any amount of monetary and fiscal stimulus will alter this reassessment of risks and changes in behavior.
I have no doubt that Trillions of central bank liquidity will spark major rallies. Trillions of fiscal spending will help stabilize economies. On the market front, all this QE and market intervention will exacerbate instability, without improving the longer-term prognosis. Indeed, as I said earlier, the current trajectory – and if I’m right on the impetus for large ongoing monetary stimulus – risks a dangerous crisis of confidence in central banking. I expect reduced risk tolerance, which equates to a tightening of financial conditions – irrespective of monetary policy.
I’ll throw out a few changes I expect to the global financial landscape. There will be reduced risk-taking and less speculative leverage. I believe there will be far-reaching changes in the derivatives markets. This massive complex has prospered on the specious assumption of liquid and continuous markets – a premise made viable only with confidence in the absolute power of central banking. Going forward, I anticipate market operators will be less willing to sell various forms of market protection. And the rising cost of such insurance will equate to less risk-taking generally throughout global markets – by investors, the leveraged speculating community, organizations and financial institutions. There will be less M&A, less stock buybacks, structured finance, and financial engineering more generally.
As for the real economy, this spending free-for-all will delay crucial economic adjustment. Moreover, it will surely solidify the perception of inequality and injustice – deepening the divide for an alarmingly divided nation. Trust in our institutions is increasingly fragile. Tighter conditions both in the markets and in bank lending will impinge recovery. For awhile, we’ll have more cautious household and business sectors. Beyond less overall spending, major shifts in consumption and investment patterns will reverberate throughout economic and financial systems.
In last week’s Credit Bubble Bulletin, I suggested that the U.S. stock market has become a “side-show oddity.” I worry greatly about the consequences of the bursting of the U.S. financial market bubble. Perhaps my bigger fears revolve around social, political and geopolitical developments.
As catalyst for the bursting of global bubbles, the pandemic has altered the world order. So many things are in the process of fundamental change – with most not yet in clear view. The upside of Bubbles, buoyed by an optimistic view of an expanding economic “pie,” is conducive to cooperation, assimilation and integration. The downside unleashes a demoralizing slide into antipathy, disintegration and confrontation.
On the geopolitical front, we’ve already seen eruptions in the initial weeks of the pandemic - Strongmen leaders in Russia and Saudi Arabia in a bare-knuckled price war. There’s back and forth enmity between the U.S. and China over the origin on the coronavirus – and in Europe, discord is stoking fears for the future of monetary integration.
I am compelled to repeat that I’m an analyst and not a pessimist. We’ll get through this, but it won’t be easy. Hopefully we’ll begin economic recovery soon. There’s pent up demand and inventories to rebuild. My heart goes out especially to so many small businesses that will struggle to survive. I see no way around a protracted economic adjustment period. I believe we’re in the initial phase of what will prove a momentous adjustment to the securities and derivatives markets – at home and abroad.