Macro Wrap-Up

Time After Time

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Time After Time

In the past few weeks, markets have moved so quickly that it’s been difficult to think beyond the next few minutes. Moves that previously may have taken weeks, even months in normal times seem to happen every hour. The standard advice we hear is to look beyond the short-term moves and think more strategically, more about the longer term. And while it is probably good advice, for tactical macro investors it is a far more complex problem than it appears. Not all markets price for the long term, and those which do can quickly become influenced by short-term events.   

Bonds are very specific in the time frame they price, because they usually have set coupon and maturity dates. When you invest in a bond, you are making a bet on the ability of the counterparty to pay over that time. 1 1 Close You are also making a bet on the opportunity cost of lending that money and the relative value of the coupon payment.   Commodities do not have maturity dates like bonds, but they are often very short-term in outlook. Commodities such as grains or energies which are either perishable or difficult to store are mostly sensitive to the supply and demand conditions at delivery times rather than some longer-term view. For example, demand for crude oil may rise in two years, but that won’t help if right now Saudi Arabia and Russia are producing too much to store in existing facilities. 2 2 Close Certain relatives of mine have been concerned that I would forget to sell my futures and accidentally take delivery of say…live cattle futures. They didn’t realize that delivery doesn’t come directly to your apartment.  

Equities are very different. When you buy the stock, you are buying an indefinite ownership stake in the company. You care about what dividends it pays in perpetuity. There is no delivery date for the company and it doesn’t cost anything to store it, other than the opportunity cost of the money you use. 3 3 Close There are transaction costs, but that is for putting on and taking off the trade, not holding it.   In theory, equities should be valued as a long-term investment, even if investors are free to sell at any time. Often that does seem to be the case. Many investors were puzzled by how low volatility in equities has been over the past few years. One potential interpretation was that stocks were taking a longer-term view and weren’t overreacting to shorter-term news. 4 4 Close Of course that doesn’t explain why bond volatility was so low. Commodity volatility held up well.   They were being priced as longer-term assets which can look past the concerns we human investors have in our daily lives outside of the market.

In the past couple of weeks, we’ve seen stock prices move on some short-term news. In particular, the spread of the coronavirus and the breakdown of the OPEC talks have led to a return of volatility. And that volatility has been because of downward moves in stocks. 5 5 Close No one worries about upward volatility. Well a few people do, but they are either extreme pessimists or have exceptional conviction in mean reversion.   There are several reasons equities suddenly could become so reactive to headlines. The first is that the news could cause a material change in the long-term economic outlook. The news may force equity investors to reevaluate the prospects for a given country or region. This isn’t always negative – a new technology could increase productivity even though this month it has not. There could also be a change in the political outlook. Events may affect the regulatory environment, which is very important to companies’ earnings and market functioning. In a worst-case scenario, the government itself could become less stable than was previously thought, which would certainly affect long-term prospects for equities.

Recently, we’ve seen some examples of how the short-term outlook becomes indistinguishable from the long-term outlook. If a company’s (or group of companies’) existence is threatened, the long-term prospects don’t really matter. This can be true in times of market stress for whole sectors and in some cases the whole market. It is the case right now for many highly indebted oil companies, some of whom need higher oil prices to earn enough money to pay their creditors. This is when an equity becomes more like a bond or even a commodity. It becomes impossible to look beyond the next payment. This is known to some as solvency.

The short-term behavior goes beyond just rational choice. In times of stress, some investors may need cash to meet margin calls or fund other losses. When systemic events occur, they create cascading cash shortages – when there just isn’t enough to go around. Investors are forced to get out of their investments to get liquidity. The folks with cash don’t want to part with it so they require a healthy discount on the securities. At this point, the market becomes like a commodity market, in that it is entirely driven by supply and demand for short-term delivery. The commodity is cash.

During the financial crisis in 2008-9, a lot of folks said that it was a liquidity crisis, not a solvency crisis. What they meant was that if there wasn’t such a shortage of cash and companies were able to stay in business through the year, their longer-term prospects were okay. But in moments of panic, it often seems like the longer-term prospects are worse than they are. That brings us to the final reason that stocks start acting like short-term markets. People overestimate the importance of the current news on the long term. We quants call this a behavioral bias among investors. You probably call it being scared to death. 6 6 Close I know you would prefer to hear something different from “to death.”  

For investors, it would not be a good idea to assume short-term news and moves are meaningless. The market in the past ten years, and to a lesser extent the last forty, has taught us that nothing matters except the long term. But investors should know that the market isn’t always the best teacher. 7 7 Close I feel like someone else has said something similar, but I can’t find the quote.   The news does matter and can affect prices for many years. Also, it isn’t necessarily true that the pricing was perfectly rational prior to the recent moves just because volatility was low. Still, as with any major liquidity event, there will be dislocations and overreactions. It helps to remember that no matter how bad it gets, equities are still not commodities. And perhaps more importantly, commodities are not equities.

What We Are Watching

U.S. Empire Manufacturing Index (Monday), NAHB Homebuilder Sentiment (Tuesday), and Philadelphia Fed Index (Thursday)
The geographic scope and disruptive impacts of the coronavirus outbreak have increased rapidly in recent weeks, meaning that data from January and February is no longer of much use to economists and market participants seeking to assess the state of the U.S. economy. This week, we will begin to see a few surveys measuring business conditions in March, which may help to provide a sense of the magnitude of the economic shock brought about by the virus. The NAHB Homebuilder Sentiment survey may be of particular interest, as the housing sector typically benefits from lower interest rates. If homebuilder sentiment deteriorates significantly, it would suggest that lower rates have not been enough to offset behavioral changes due to the outbreak.

FOMC Meeting (Wednesday)
Earlier in March, the FOMC held an emergency meeting and decided to lower interest rates by 0.5%. Since that time, however, financial conditions have continued to tighten as concerns over the impact of the coronavirus outbreak have escalated. Fed Funds futures price a high likelihood that the Fed moves its interest rate target down by a full percentage point at its upcoming meeting, which would bring the target range to 0%-0.25%. Such a move might be supportive of risk sentiment, particulary if paired with guidance on additional tools that could be employed if conditions continue to worsen. 

Bank of Japan Meeting (Thursday)
The Bank of Japan has repeatedly expressed the ability and willingness to ease financial conditions further if needed. However, the BoJ has appeared hesitant to move rates further into negative territory, causing its guidance to be met with increasing skepticism among some market participants. With an obvious need for additional stimulus, the Bank of Japan will now have to show its incremental ability to ease. Available policy options include reducing interest rates further, adjusting its yield-curve-control policy, and introducing new funding schemes that benefit small and medium enterprises, among others. With the Fed, the Bank of England, and the European Central Bank having delivered various forms of accommodation, it’s the Bank of Japan’s turn to prove that its policy options have not reached their limit.    

 

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