Investors have pulled $83 billion from emerging markets since the beginning of the COVID-19 crisis, the largest capital outflow ever recorded, and the IMF and the World Bank are calling on G20 countries to show relief in dealing with their emerging market counterparts.

Following a meeting of G20 finance ministers and central bank governors on Monday March 23, IMF managing director, Kristalina Georgieva predicted there would be a global downturn at least as bad as the 2008 financial crisis but there will be a recovery in 2021.

Georgieva pointed out that advanced economies were in a much better position to respond to the crisis.

“Many emerging markets face significant challenges, they are badly effected by outward capital flows and their domestic activity will be severely impacted as countries respond to the epidemic,” she said. “We are particularly concerned about low income countries in debt distress. An issue we are working closely with the World Bank.”

Meanwhile the World Bank Group president, David Malpass, made a call to action to the G20.

“I urge all official bilateral creditors of the poorest countries to act with immediate effect to help International Development Association countries through debt relief, allowing the countries to concentrate their resources on fighting the pandemic. In many cases this will require comprehensive and fair debt restructuring that includes NPV reductions sufficient for restoring debt sustainability,” he said.

“I’m calling on the G20 Leaders to allow the poorest countries to suspend all repayments of official bilateral credit until the World Bank and the IMF have made a full assessment of their reconstruction and financing needs.”

According to commentary on Nasdaq, shares of iShares Core MSCI Emerging Markets ETF entered into oversold territory on Monday, with trades as low as $36.24 per share. Its 52-week range is $35.86 per share, with $55.45 the high in that time frame.

Nasdaq defines “oversold territory” using its momentum measuring Relative Strength Index, with a stock considered oversold if the RSI falls below 30, on a scale of one to 100.

In the case of iShares Core MSCI Emerging Markets, the RSI reading hit 29.9. At the same time the S&P 500 sitting at 29.8.

“A bullish investor could look at [the] 29.9 reading as a sign that the recent heavy selling is in the process of exhausting itself, and begin to look for entry point opportunities on the buy side,” the commentary said.

 

Will there be a V-Shape recovery?

Commentators agree that the recovery to markets and the economy depends on the speed of the containment.

“The outlook for global growth for 2020 is negative, and we will have a recession at least as bad as the GFC or worse, but expect a recovery in 2021,” the IMF’s Georgieva said.

“To get to [the recovery] it is paramount to prioritise containment and strengthen health systems everywhere. The economic impact will be severe but the faster the virus stops the quicker and stronger the recovery will be.”

Campbell Harvey, Professor of Finance at Duke University said this health crisis was different to the global financial crisis.

“It’s not like the GFC which got worse and worse over the years,” he said. “It is moving faster but also; it can be resolved faster.”

He pointed out that the short horizon could be fairly short and that there was a chance there could be a dramatic downturn in the short term followed by a dramatic upturn.

“There is a sudden stop where the country grinds to a halt but it can also be a sudden start,” he said. “The coronavirus outbreak looks really terrible in the short term but if we play our cards right it will be a V-shaped recession rather than a U or an L- shaped recession.”

Professor at the London School of Economics and Political Science, Iain Begg, agreed the recovery will depend on the length of time of the lockdown.

“We don’t know how severe the impact of the lockdowns will be on the economy. I can imagine a situation where it is quite severe if the lockdown persists for a long time. There are many sectors that are closed for the duration of the lockdown,” he said, naming tourism, retail, travel and some parts of manufacturing.

“Whether it lasts three weeks or three months is the critical variable. Some sectors like healthcare will boom but the vast majority of the economy will be affected. So it could be a much more significant sharp recession after which, assuming the virus is conquered, there could be a very sharp recovery. The timing of this is so uncertain that predictions are almost pointless.”

 

Even for long term investors who pride themselves on the big picture and horizons stretching far into the future, the unprecedented change of recent weeks is hair-raising. Wild markets, deserted financial centres and billions and billions of dollars of government support to fight the impacts of the coronavirus have become the new normal.

Enough liquidity on hand to take advantage of buying opportunities once they arise and comfortably pay benefits is crucial.

Speaking at CalPERS’ March board meeting, held by teleconference because of virus concerns, CIO Ben Meng reassured efforts to put liquidity centre stage over the last year have paid off. Strategies included lowering the discount rate of return (from 7.5 per cent to 7 per cent) and shortening the amoratisation period to 20 years. Centralising governance of the investment office to give a total fund rather than individual asset class view has also helped manage liquidity, he said. CalPERS liquidity was nearly $4 billion at the end of 2019.

Other strategies like an allocation to long-duration Treasuries and factor strategies in the equity allocation, estimated at $62 billion at the end of last year, have “helped mitigate the impact of the severe decline in public equity allocation,” he said. Even so, at the end of last year the bulk of the fund’s equity portfolio ($143.8 billion) was in traditional cap-weighted index strategies which have felt the impact of plunging markets most keenly. CalPERS currently puts its AUM at $335.13 billion compared to $353 billion a week ago.

Meng also warned that extreme volatility has seen the fund deviate away from its strategic asset allocation targets as falling markets crunch into allocations.

“If volatility remains, we will reach the outer range of these targets. We are monitoring this, and have a plan in place,” he reassured.

As for positioning portfolios to benefit, France’s Fonds de reserve pour les retraites (FRR), the €32.7 billion pension reserve fund, is ready and waiting to build out its equity allocation in line with new regulations, says Olivier Rousseau, executive director, FRR.

“If the slump increases it is very uncomfortable short-term, but assuming the world is not coming to an end it will mean good entry points for additional equity investments.”

Charles Van Vleet, assistant treasurer and chief investment officer at the $12 billion corporate pension fund for US aerospace and defence giant Textron reports that the fund’s tail hedges have worked well to mitigate the drawdown. These include long duration STRIPS, long US$ and Yen vs. A$ and Euro and being overweight consumer staples.

Now he is rebalancing or averaging into the markets with preferences, so far, comprising publicly listed business development companies (BDCs) and Closed End Mutual Funds (CEFs).

“Both of these products suffer indiscriminate selling by retail investors and now trade at deep discounts to book-value,” says van Vleet.

He believes markets will likely trade down with extreme volatility until the second derivative – or rate of change in the rate of change – of contagion begins to improve.

“It is important to keep in mind that this is not a cyclical event like 2001, or a financial structural event like in 2008, but an exogenous shock. I would expect the recovery to be quicker than 2001 or 2008. Equity markets will improve long in advance of earnings.”

Not the GFC

Of course, at times like this all pension funds espouse the long-term mantra.

Mark Fawcett, CIO of the UK’s £8 billion National Employment Savings Trust, NEST, the DC workplace pension scheme launched in 2011, stresses NEST’s diversification and long-term strategy puts the fund out of harm’s way.

“Pension saving is a long game – people can be saving for up to 40 or even 50 years. Younger savers should comfortably ride out shorter term fluctuations and at NEST we take steps to protect members’ pots as they get closer to retirement.”

At the UK’s Universities Superannuation Scheme (USS), where an investment team of 150 used to working in a customised environment and desk communication has been split up with most staff working from home, there is no sense of panic. The emphasis is on careful consideration rather than undue haste, reassures new CIO Simon Pilcher.

“We are calmly navigating our way through this storm,” he says.

A whirlwind that has now left USS breaching one of its funding measures as a result of the downturn in financial markets.

“We believe this will ultimately be a short to medium term shock (albeit a very severe one) but that this is not likely to last for a decade or more, in the way that the great financial crisis of 2008-9 did,” says Pilcher.

At USS, fixed income haven assets have provided a rich seam.

“Fixed income has performed very strongly in recent weeks (especially so in the US), and in general has done better than UK index-linked government bonds that many pension schemes invest in.”

Now the fund is “trading out of those that have performed best in order to buy other bonds that we think will perform better over the medium term,” he says.

Navigating extreme volatility in fixed income has been a headache for the big Dutch schemes which hedge their liabilities in the interest rate swap market.

Expensive swap rates caused by shrinking liquidity and extreme volatility are challenging, says a spokesperson for APG where 90-95 per cent of staff now work from home.

Private equity allocations are also at risk, flags Pilcher.

USS is working closely with the management teams of companies in which it holds an ownership interest, in its 40 per cent private markets allocation, to help them navigate challenging times. This along with an eagle eye on investing in private market opportunities that will “pay off over the long term,” he says.

Time for MMT?

Looking to where the crisis might bleed next, talk increasingly focuses on a credit. Since the financial crisis the corporate sector has built up a debt exposure it might not be able to service thanks to disruption in supply chains, reduced global growth and lower earnings – despite rock bottom interest rates. A recent OECD report says that at the end of last year the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5 trillion, double the level in real terms against December 2008.

But Textron’s van Vleet doesn’t see a credit crisis. Credit is in secure hands, where there is no term-structure mismatch, he explains.

“In past cycles, banks and hedge funds were forced sellers when their source of funding went away. Credit is now in the hands of private-credit structures, BDCs and ETFs. There is no liquidity in private-credit structures. BDCs and ETFs do not require transactions to flow through the fund. They simply trade at a discount to book value.”

He also notes that defaults are generally not a function of not being able to service the debt but rather not being able to roll-the debt.

“If the Fed, Treasury and Congress start to do the right thing, credit facilities will get support,” he says.

Yet doing the right thing requires a different approach to ever lower interest rates. Governments need to help people pay medical bills and mortgages, he says.

“Topping up strategic oil reserves is equally lacking.”

Instead he calls for income-replacement and small business loans, akin to principles espoused in Modern Monetary Theory, which argues governments are in control of issuing their currency and can ultimately issue as much as they need.

“We need to build direct programs that get money into the hands of labor and small businesses; not programs that allegedly trickle down via FOMC rates, QE or strategic reserve purchases.”

Meanwhile, Europe’s empty supermarket shelves could foretell another, longer-term shift.

Maybe it’s time for globalisation patterns to change and nations to produce more of what they consume, suggests Danish fund PFA’s CIO, Kasper Lorenzen.

“The global value chain has been closed for a while and it’s probably going to get worse. Firms and individuals are being reminded that it is great to have parts of your production in other parts of the world, but this comes with risk,” he says. “This is not going to be over, even if there is a cure for the virus tomorrow. We are going to learn something from this and that could be a reversal in globalisation.”

Academics at Chicago Booth looks at three important pillars of the economic policy response to the COVID-19 crisis. First, following the advice of medical experts, we must do all we can to spread the number of infections over time, or “flatten the curve’’. Second, policies should facilitate production and decision-making in a temporarily socially distanced world. Third, we should prepare to make the post-virus recovery as rapid as possible. Importantly they say this is a unique opportunity to make investments in human capital.

Read the paper here 

Last Thursday, March 12 the US Senate Democrats’ Special Committee on the Climate Crisis heard from industry experts, including Bob Litterman and Frederic Samama, on the economic risks of climate change. They all pushed for a price on carbon and for action, now.

The climate crisis is fundamentally a risk management failure Bob Litterman, co-founder of the Black Litterman Model, told the US Senate Democrats’ Special Committee on the Climate Crisis last week.

Climate change is a risk management failure that can and must be fixed immediately, he said, with new tax incentives the key to much-needed change.

“We are not pricing climate risk; not creating appropriate incentives to reduce emissions: a tragic and potentially catastrophic mistake,” he said. “Incentives are currently directing capital in directions that increase emissions, causing a growing accumulation of greenhouse gases in the atmosphere, which in turn is creating a rapid increase in the risk of permanent damage to the planet and the well-being of all future generations. While voluntary actions are welcome, they will not be enough. Changing incentives is the key that will lead to the massive changes in economic investment that are required.”

Litterman, who is a partner at Kepos Capital and was former head of risk management at Goldman Sachs, was clear in his message that the absence of appropriate risk pricing is the root cause of the climate crisis.

“Government incentives in the tax code encourage the creation of carbon emissions and thus needlessly waste whatever remaining capacity the atmosphere has to safely absorb greenhouse gases,” he said.

“Time is of the essence. Given enough time virtually any problem can be addressed. In risk management, time is a scarce resource. It’s when one runs out of time that a risk can turn into a disaster. With climate change we do not know how much time we have before the planet’s climatic system is pushed past a catastrophic tipping point, beyond which the consequences would become non-linear and irreversible.”

Frédéric Samama, head of responsible investment of the largest fund manager in Europe, the $1.8 trillion French-based Amundi, was also one of a handful of experts who gave testimony in front of the US Senate Democrats’ Special Committee on the Climate Crisis, chaired by Senator Brian Schatz.

His testimony focused on The Green Swan, published with authors from the Banque de France, the Bank for International Settlements (BIS), and Columbia University about climate change risks to central banks and regulators.

He told the committee that climate change could create some potentially extremely disruptive events that underlie systemic crises and, importantly, he agreed that new models were needed for scenario analysis and stress testing.

“Traditional backward-looking risk models do not capture future risks,” he said. “…the deep uncertainties are such that no single model or scenario can provide a full picture of the macroeconomic and firm-level impacts caused by climate change. Central Banks must recognise the limits of their existing analytical and policy toolbox.”

In an urgent call to action he urged governments and policy makers to move forward with carbon pricing, calling on central banks to play an additional role by helping coordinate the measures to fight climate change.

“We must obviously move forward with carbon pricing.  And we must explore new policy mixes (fiscal-monetary-prudential) to better address the climate imperatives ahead. We must reform international monetary and financial systems to recognise climate stability as a global public good. We must systematically integrate sustainability criteria in the financial sector.”

Litterman reminded the committee that the purpose of risk management is not to minimise risk.

“The purpose of risk management is to recognise risks, and to warn when they are not being priced appropriately,” he said. “Think about what caused the last financial crisis. That was a classic case where we didn’t price the systematic risk in mortgages. Too much risk was created, and it blew up on us. Let this be a clear warning: the absence of appropriate risk pricing is the root cause of the climate crisis. Government incentives in the tax code encourage the creation of carbon emissions and thus needlessly waste whatever remaining capacity the atmosphere has to safely absorb greenhouse gases.”

Litterman told the committee that due to both the risk and uncertainty associated with climate change, erring on the side of caution was important, which means an even higher price.

“Prudent risk management therefore implies that an incentive should be immediately applied globally to reduce greenhouse gas emissions at a rate that balances the future risk against the current cost. What makes pricing carbon extremely urgent is that we have already created unacceptable risk, and with each year of delay in pricing climate risk the expected peak temperature, and therefore the risk from climate change, increases at an alarming rate,” he says. “Investors are waiting impatiently for the appropriate incentives to reduce emissions to be instituted in the tax code. Then, and only then, will the awesome power of the financial system be able to address this existential threat. Meanwhile, capital is flowing freely in the wrong direction, emissions continue to rise, catastrophic climate-related damages proliferate, and the threat of truly cataclysmic impacts increase. Risk management provides the frame through which the climate crisis can, and I believe will, be successfully addressed.”

A former adviser to the US Federal Reserve said increased volatility in bonds and turmoil in the money markets from the outbreak of the coronavirus could signal a looming credit event despite the Fed’s latest bid to inject liquidity into the system.

Danielle DiMartino Booth, who advised the Dallas Federal Reserve between 2006 and 2015, says the economic fallout grows with each stressed firm that taps its credit line for emergency liquidity; the LIBOR-OIS spread spike indicates concerns in the credit market are accelerating and all of this is exacerbated by the boom in private debt and fixed income ETF asset classes.

Her comments come just as the Fed announced on Tuesday that it will re-open a special credit facility to purchase short-term corporate paper from issuers – a liquidity tool not used since the global financial crisis. It has also re-opened the primary dealer lending facility which gives large banks to borrow cash against corporate bonds.

DiMartino Booth, who is the chief executive of Quill Intelligence, said opening the ‘discount window’ was positive since the unprecedented emergency measures taken by Fed to calm stricken investors including reducing interest rates to zero had failed to put a floor under prices.

Even so, the emergency measures taken by the Fed so far including restarting quantitative easing has failed to dampen market volatility that had resulted in the S&P 500 Index plummeting nearly 30 per cent in a month. The central bank said it would buy US$700 billion worth of treasury bonds which is on top of the massive US$1.5 trillion injection into the bond market last week.

“As ugly and awful as the thought has been, we haven’t seen credit completely collapse,” DiMartino Booth said. “Usually by the time you a get a 30 per cent decline in the stock prices, you’re much further along in the cessation of the credit cycle. This has been the fastest 30 per cent decline in the history of the US stock markets.”

Normally, she added, you would have a bit of time to get the unwind in the credit cycle going. “But inside the space of a few days, you have airlines asking for bailouts because they are so overleveraged, and companies everywhere drawing down entire credit lines from the banks.

Credit cycle unwind

DiMartino Booth said the starting point with the credit cycle unwind is the end point for the last credit crisis.

“We are starting at the zero bound,” she said. “We are starting with the balance sheet at the biggest it has ever been.

“The only question now in terms of making sure there is an orderly unwind in the credit markets is whether the Fed’s future tools will be sufficient to address this and we just can’t know,” she said.

Credit has come under intense pressure anew. Whereas initially the correction was more violent in equities, credit spreads are widening as deals start to get postponed.

DiMartino Booth said that a sign of stress in the banking system was the gap between the Libor– OIS spread, which was now at the widest level since the financial crisis. The spread – which can be measured by graphing the three-month LIBOR against the approximate effective federal funds rate – rose to 88 basis points last week.

“It has still got a long way to go before spiking to the 284 basis points we saw during the financial crisis,” she said. “But the expansion, together with the crude oil prices, are starting to tell us that there is concern about the unwind beginning in credit market.”

DiMartino Booth said even more worrying was that certain structures that hold credit in the US had not been tested until now and the corporate debt market has just surpassed the $10 trillion mark.

“We have seen the discount to net asset value of fixed-income backed ETFs absolutely collapse and that is indicative of the fact that the collateral backing these illiquid funds is not trading and this has always been the nightmare scenario for fixed income investors,” she said.

“The fact that investment in these ETFs have theoretical instantaneous liquidity will be stress tested and we are about to see what happens.”

Aside from ETFs, the economic adviser said there were other asset classes within debt such as leveraged loans with more than 80 per cent covenant lite — “so you are not going to know when these blow up until they have blown up, past tense,” she warned.

Hardest hit sectors

Small business subsectors that will be the most harmed are those which interface directly with the US public when its citizens are face-to-face.

Unfortunately, she said, the sectors that are being hit the hardest by the coronavirus “have very shaky credit.”

DiMartino Booth said that the US now has a private debt market worth US$800 billion and this has led to greater speculation in that market as the search for yield has pushed investors to take ever greater level of risk by stepping down into smaller and riskier companies.

“It’s with good reason that there is extraordinary focus on small and medium enterprises,” she said. “But these borrowers are not the easiest to track in the aggregate, nor are most investors exposed to risks associated with lending to those with the most fragile cash flows. The fallout from a big dislocation in small businesses would be brutal for the US economy.”

DiMartino Booth said the potential for a credit crisis is much higher when a series of companies rush to their bank and tapping out their credit lines. “It’s a sign companies don’t have the cash flow to withstand any in economic blow.”

Under the stewardship of new CIO, Kasper Lorenzen, Denmark’s PFA has survived the first wave of coronavirus-fuelled market mayhem.

Lorenzen, who joined the $86.3 billion PFA, from the country’s statutory pension fund the $125.7 billion ATP six months ago, told Top1000funds.com the fund’s belief in risk parity and a balanced portfolio resulted in a “reasonable” risk-on allocation at the end of last year, and for the first two months of this year.

“Equities did fine, and rates kept dropping so a balanced portfolio did really well,” he says.

So well, in fact, by the end of February 2020 the portfolio had returned as much in the first eight weeks of the year as it was expected to return over the course of the whole year. That, combined with a belief that coronavirus was “more than flu,” and would have severe supply consequences for the world economy, led PFA’s investment team to take profit on some of the equity positions in its return portfolio.

“We scaled down risk,” says Lorenzen, speaking from the fund’s Copenhagen headquarters before the country was put in a virus-induced lock down along with the rest of Europe. “Sometimes you get it right, and sometimes you don’t,” he says.

With global equity markets experiencing a “big correction” and government bond yields crashing to historic lows, he is minded that a rebound may be in the offing. “This is too much, too quickly,” he says. “We’ve put on some short-term adjustments.”

That is not to say he doesn’t have a keen awareness of the long-term structural changes the virus could trigger should patterns in globalisation, already under pressure from trade wars, populism and “now this,” shift.

“The global value chain has been closed for a while and it’s probably going to get worse. Firms and individuals are being reminded that it is great to have parts of your production in other parts of the world, but this comes with risk,” he says. “This is not going to be over, even if there is a cure for the virus tomorrow. We are going to learn something from this and that could be a reversal in globalisation.”

Lorenzen also believes the fund’s response to the crisis has been helped by changes he put in place on his arrival.

When Lorenzen joined PFA six months ago, he restructured the investment organisation’s meeting structure. It involved re-jigging which members of the team are part of the decision-making process, and which are involved in management, leadership or fund management.

“How we meet, and the agenda, is the heartbeat of the investment organisation. We needed a structure that could execute, and work with strategy on a daily basis.” It’s an evolving process that will be adjusted and developed over time, he says. “It’s difficult setting up an optimal organisation from the beginning.”

He has also turned his attention to investment strategy, where much is running well at the pension fund he needed little persuasion to join, having worked at PFA as a portfolio manager before joining ATP in 2007.

The fund’s growing alternatives allocation is a particular jewel in the crown, overhauled in 2016 when it was just 2 per cent of AUM and comprising older fund commitments and a few direct investments, to now account for around 20 per cent of AUM and invested across private equity, credit and infrastructure. Investments include TDC, the Danish incumbent telecommunications provider and a stake in the Walney Extension Offshore Wind Farm, located in the Irish Sea.

“If we are presented with good deals, we might take our private markets allocation to 25 per cent. But if we don’t see anything we like, the number of deals will gradually expire, and the allocation might go lower. It all depends on what deals we are presented with.”

The unlisted allocation is run by an internal team of around 15 – where the focus is origination, execution and leadership – plus a select group of strategic external managers. Manager relationships are based on “good strategic dialogue” that ensure efficiency and transparency around co- investment. “Our investment process in private markets allows us to execute when opportunities arise and be fairly firm on how we communicate with some of our funds. They know what we are after, and have certainty around our appetite,” he says.

Risk parity

However, there is an important element of the portfolio he is keen to develop. Namely, introducing a framework across private and public markets that would allow the team to compare risk, an area PFA has already done much work, but where he is keen to push further.

Many risk-parity investors don’t apply the strategy to illiquid investments, but at ATP Lorenzen included illiquid alternatives (private equity, real estate and infrastructure) under a risk-parity umbrella in a structure that gave a common currency, or shared risk denominator, to public and private assets. It allowed the fund to dial risk up, or down, in what he calls a “very useful” way.

“At PFA we are now working to create a similar risk framework that will allow us to specifically compare the risk of public and private markets,” he says.

For example, the new visibility will allow the fund to act if it sees too much risk in private markets by hedging some of that in public markets.

“Alternatively, if we have a good, robust private markets portfolio we want to be in a position to take on a little more risk in public markets to capitalise on that diversification benefit,” he says, adding that building an alternative risk framework will involve looking at each individual private market deal in a bottom up approach within the organisation.

Building out risk parity in private markets is neither a dramatic new strategy nor a particularly long journey ahead. PFA already looks at its portfolio through a risk lens. It has a 15-year history of using derivatives and has long hedged its liabilities.

Instead, it’s more of a fine-tuning that speaks to all Lorenzen’s experience.

“I have bought a mindset to PFA that was established at ATP over the last decade and is now is in my DNA. It comprises separating the hedging and investment activity so that hedging in one metric, and investment risk is measured using a different metric. Not being too levered against reserves – and taking on the right amount of risk.”