Covid Uncertainties
Doug Nolan
It significantly raises the stakes for a potential nightmare scenario: with less than five weeks until election day, the President contracts COVID-19. As if this election cycle wasn’t chaotic enough.
As CNN put it:
“A stunning new twist in a tumultuous year, throwing an election that is only 32 days away into chaos and raising the grave possibility of more American crises over governance and national security at an already perilous moment.”
And from the Wall Street Journal:
“The law of unknown consequences now is in full effect. The uncertainty starts, of course, with the actual state of the president’s health going forward. In the coronavirus pandemic, the world has seen that the difference between a mild case and severe reactions can be an enormous one.”
Whether it’s the recession, Credit issues, COVID consequences more generally, or even the President’s illness – markets have been well-conditioned for “mild case.” The S&P500 ended Friday’s session down just under 1% (broader market actually closed higher on the day), a notably mild reaction to such a potentially destabilizing development.
The perceived higher likelihood of a stimulus deal helped underpin financial markets. A Friday evening Bloomberg headline: “Escalating Chaos Again Proves Incapable of Derailing the S&P 500.”
Clearly, markets have grown comfortable seeing bad news in positive light. But to see the President – less than 24 from his positive test result - board Marine One for a planned several-day stay at Walter Reed Medical Center is unsettling to say the least.
A phenomenal market backdrop has become only more so. Let’s take the analysis back a year as we strive for an informed perspective. Federal Reserve Credit jumped $170 billion (to $3.946 TN) in the four weeks preceding October 2, 2019 – as the Fed restarted QE in response to heightened repo market instability. Fed Credit expanded an additional $252 billion between October and February 19th.
Bloomberg’s Tom Keene (September 23, 2020 TV interview): “It’s all great. I look at the Fed policy and the hope and the prayer. But the great conundrum out there… is this fear of asset Bubbles. Is a consumer discretionary stock with a 32 P/E the definition of an asset Bubble? …Are these asset Bubbles?”
Mike Schumacher – Wells Fargo Securities Head of Macro Strategy: “The Bubble term is interesting. People talk about it quite a bit. It’s hard to define it. What exactly is a Bubble? To me a bubble is something where prices explode upward with no tie to fundamentals and no clear link to policy changes. And what we’ve had in the last six months is a little different, because policy shifts have really boosted assets dramatically. So, I’d say it’s too soon to tell the Federal Reserve or the ECB that they’ve really put forth a Bubble. But that could happen in six or twelve months.”
“A bubble is something where prices explode upward with no tie to fundamentals and no clear link to policy changes.” There’s a big hole in this definition: Government policies typically play an instrumental role in Bubble Dynamics.
Fed Credit has expanded $3.294 TN over the past 56 weeks, an unprecedented expansion of central bank liquidity. Did the Fed further inflate a historic speculative Bubble, exacerbating market and economic fragilities heading into a pivotal election?
It is almost universally accepted the Fed has acted responsibly and effectively in countering negative pandemic effects. Markets remain near all-time highs in the face of economic weakness and myriad uncertainties. Booming equities and Credit markets have provided powerful underpinnings to the real economy.
For most, the Bubble debate is not even relevant. General sentiments are harmonious with Treasury Secretary Steven Mnuchin’s comments from a couple weeks back: “Now is not the time to worry about shrinking the deficit or shrinking the Fed balance sheet. There was a time when the Fed was shrinking the balance sheet and coming back to normal.
The good news is that gave them a lot of room to increase the balance sheet, which they did. And I think both the monetary policy working with fiscal policy and what we were able to get done in an unprecedented way with Congress is the reason the economy is doing better.”
I had serious issues last September when the Fed introduced this notion of “insurance” monetary stimulus, moving forward with aggressive measures despite stocks near record highs and unemployment at 50-year lows. It was a move that clearly risked ratcheting up already severe market distortions.
Then in January the risk of a highly problematic global pandemic became increasingly apparent.
U.S. equities, however, completely disregarded this risk well into February (record highs on Feb. 19th). The S&P500 returned 16.7% between September 1st and February 19th, with the Nasdaq100 up 27%.
Were Fed stimulus measures responsible for extraordinary pre-COVID market gains? Did the restart of QE contribute to market COVID complacency?
And most pertinent to this analysis, did the powerful advance and risk complacency contribute meaningfully to latent market fragility?
Or, more directly, did a Fed-orchestrated Bubble create a dangerous speculative market dynamic whereby risks were disregarded until reaching a point where the dam broke and crash dynamics erupted? Did “policy changes” directly contribute to acute Bubble fragilities and a near market breakdown?
The VIX index traded as low as 14.49 on February 20th – a remarkably depressed level considering escalating pandemic risks. I would strongly argue the low cost of market “insurance” was a direct consequence of the Fed’s September adoption of an “insurance” policy stimulus approach. Why not sell put options and other market derivatives insurance with the Fed committed to moving early and aggressively to counter nascent market instability?
I’ve over the years used a flood insurance analogy in an attempt to underscore anomalies in market “insurance.” It was as if in February the cost of flood insurance remained unusually cheap in the face of torrential rainfall – knowing the barriers local authorities had erected up the river were restricting the water-flow.
The longer a Bubble’s duration the easier it becomes to rebut its existence. Meanwhile, Bubble effects over time become more structural. Protracted bull markets crystallize perceptions, while financial innovation ensures myriad instruments and strategies that work to perpetuate bullish flows and trading dynamics.
There becomes little doubt. It’s best to remain fully invested. Managed risk, not by adjusting portfolio composition but with options and other derivatives. “All weather” portfolios can be structured with Treasuries and other diversification tools functioning as internal hedges. And, in the event of acute market instability, there are myriad highly liquid ETFs that can be immediately shorted (or, in other cases, purchased) to efficiently hedge market risk.
Given time, risk embracement ensures mighty and unflagging flows into the risk markets. The bull market functions elegantly – validating perceptions of robust fundamentals and market conditions. Risks are downplayed, with complacency reinforced by readily available risk insurance and risk-mitigation strategies. It all works miraculously until it doesn’t - until the eventual disruptive eruption of “risk off” de-risking/deleveraging.
It is impossible for “the market” to offload risk. Any time a meaningful segment of the marketplace seeks to de-risk there becomes the critical issue of who has the wherewithal to “take the other side of the trade.”
With market “insurance” remaining so inexpensive, it made sense back in January and February to maintain a “risk on” posture while also purchasing put options and other derivatives to hedge potential pandemic risks. Yet the accumulation of huge quantities of option protection created vulnerability to downside market dislocation. If large amounts of flood insurance were purchased and then the dam breaks – it immediately becomes a systemic issue.
When pandemic risk materialized (economic lockdowns, acute uncertainty and fear), those that had sold market insurance rushed to sell underlying instruments (futures, stocks, ETFs, etc.) to (dynamically/“delta”) hedge their rapidly expanding risk exposures. At the same time, a highly speculative market experienced an abrupt bout of liquidation.
All the plans to sell highly liquid (equities and corporate bond) ETF shares – the liquidation of speculative long positions and hedging-related shorting - quickly sparked illiquidity, dislocation and panic.
What did we learn from such a terrifying experience? That “whatever it takes” Federal Reserve measures will embrace trillions of liquidity creation; the Fed is willing to expand purchases to include corporate bonds, ETF shares and, surely at some point, stocks; there are no longer limits to the type and scope of various Fed special financing vehicles; and the Federal Reserve is willing to greatly expand the scope of international swap arrangements.
We’re now a month away from pivotal elections with a high probability of general chaos, contested outcomes, and protracted uncertainty and instability. And now the President is in the hospital with COVID; infections are mounting within the government ranks; and general disarray has engulfed Washington. At about 3,350, the S&P500 remains within striking distance of last month’s all-time high.
The bottom line: The November 3rd election could be the most heavily hedged-against event in market history. Moreover, the most hedged event comes in the most speculative of market backdrops – which follows history’s greatest expansion of central bank liquidity. Tinderbox.
The marketplace has had months to purchase put options and other derivatives “insurance.” Too much of the marketplace has acquired products or adopted trading strategies that are expected to offload risk in the event of a meaningful market drop.
In the event of negative developments and a resulting market downturn, massive sell-programs would kick in as sellers of market insurance move to hedge escalating risks. Moreover, an extraordinarily speculative market is susceptible to any shift in risk tolerance.
In short, the potential for a self-reinforcing cascade of selling and market dislocation is today even greater than March.
Why do markets remain so dismissive of election-related risks and latent market fragility? The Fed, of course. And this has created a dangerous dynamic. Markets have become completely incapable of adjustment and correction. The nightmare scenario would see problematic developments, market dislocation, and Fed impotency in the face of acute market instability.
Markets, of course, have faith in “whatever it takes”, ensuring nightmares don’t become reality.
But years of QE and bailouts (certainly including March) have nurtured a high-risk Bubble backdrop with the potential for mayhem.
Markets needed to have been left to stand on their own. The pandemic unleashed myriad risks – including market and economic dislocation, social upheaval and, even, the President and top government officials becoming ill. The pandemic elevated the risk of social, political and geopolitical instability. And it was not the Fed’s role to have so numbed the markets to risk. Such numbness has only exacerbated market and financial fragilities.
We’re now living the perilous consequence of the Fed using the securities markets as its key mechanism for system reflation. The system would today be less fragile had air been allowed to come out of equities and corporate bond Bubbles. Instead, highly inflated Bubbles create increasingly unwieldy risk dynamics in a pandemic backdrop of extraordinary instability and uncertainty.
We’re about a month from a potentially cataclysmic market reaction in the event of a highly unfavorable election outcome. I’ve written this in the past.
Contemporary finance works miraculously so long as financial claims and asset prices continue inflating. It just doesn’t function well in reverse. And, importantly, the degree of dysfunction worsens after every repeated market bailout and resulting speculative Bubble resurgence.
Bloomberg’s Lisa Abramowicz: “Fund manager after fund manager has come on this show and said that we are at risk of creating an asset price Bubble if not having created it already. How does that factor into your calculus about when to tighten policy?”
Federal Reserve Vice Chairman Richard Clarida: “Well, that’s a good question, and obviously financial stability is always – and certainly as Powell said – an important consideration. We get regular briefings on financial stability. We issue a twice-yearly report, and we’re very attentive and attuned to that risk. But it’s also important to remember, Lisa, we have a dual mandate assigned from Congress which is maximum employment and price stability. If, hypothetically, we were to become concerned that financial stability put our maximum employment and price stability goals at risk, then we’d have to factor that in. But Lisa, we also believe that monetary policy – raising or lowering rates – is a pretty blunt instrument. And our inclination and our preference at the Fed is to work with other agencies on regulation, supervision, bank liquidity and other dimensions than simply raising or lowering rates to deal with financial stability.”
“If… financial stability put our maximum employment and price stability goals at risk…” “A consideration”?
Clarida’s comment gets right to the heart of the problem.
Financial stability should never have been subordinate to prices and employment; it is, instead, the overarching mandate to be nurtured and safeguarded with intense focus and steadfast resolve.
We’re today in the most financially unstable environment of my over 30 years of analysis.
Hopefully the President recovers quickly, the election goes smoothly, the pandemic abates, social tensions subside, and a semblance of normalcy returns.
But even in the unlikely event of a series of best-case outcomes, this historic Bubble will continue to overhang financial stability.
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