Capital markets are supposed to be free, where no manipulation occurs, where the equilibrium of risk-reward is realized and where true price discovery exists. Let’s step out of our bubble and ask ourselves, is this assumption true in the current market?
Market Manipulation
Every trader that works in the markets, has to go through compliance training to show they know they are not allowed manipulate markets and one of the regulators main roles is to catch and punish any trader or company that is found to be guilty of doing just that; strategies like stacking the bid or the offer or executing wash trades. Market manipulation usually comes with large fines but potential jail time is on the cards if found guilty; it is a serious offense – unless you are a Central Bank and write the rules of course:
Chart 1: US Investment Grade [AAA] Corporate Spread
Source: ACE Capital Investments, Alternative Global Macro – April, 2020 Edition
In the recent market falls, as expected, yields on corporate debt flew up as companies shut down, revenue takes a hit and thus they have an increased probability of a default. As the world battles covid-19, the Federal Reserves (Fed) decided that they would step in, like a good big brother does in a fight, and directly purchase companies’ debt. We can see from Chart 1 above, yields crash back down once they step in. Nothing has fundamentally changed with companies’ ability to pay their debt; the decrease in yield is solely down to manipulation on by the Fed.
True Price Discovery
Here, we look at the alignment between the physical economy and the financial economy. Traditional economic condition of unemployment, retail sales and consumer sentiment are jump-off-the-chart poor.
The same time the US lost nearly 20% of its workforce, manufacturing had its worst ever decline [-8.7%] and consumer sentiment was at a multi-year low [71.0], the equity markets had one of its best performing months in decades (see chart 2). Does true price discovery exist anymore? Given the dislocation between the physical and financial economies, we argue it does not.
Chart 2: SPX Jan 2020 – Apr 2020
Source: ACE Capital Investments, Alternative Global Macro – April, 2020 Edition
Equilibrium of Risk-Reward
Different asset classes and different assets have different risk-reward relationships. Equities are high earning but are subject to significant drops in prices – high risk-high reward. Bonds produce lower returns but have much lower risk of significant losses. You can move up and down the debt structure to increase your yield for increasing risk of default [investment grade through junk bonds]. You knowingly take on the larger risk of default in the bad times in order to reap the reward of the higher yields in the good times.
The ‘free’ capital markets are supposed to reward good companies and penalize bad ones. A lot of companies are currently finding themselves short of cash. During the bubble, the executives paid themselves handsome bonuses instead of building up a large enough cash reserve for a rainy day. Investors wanted higher yields and therefore bought debt of lower creditworthy companies. Up to recently, they have been earning their higher yield for taking on that company’s risk. Now that it’s a rainy day, shouldn’t they have to pay the piper and take the default hit? After all, that’s the risk-reward game that we all play by investing.
Company executives who paid themselves instead of building up cash reserves and investors who enjoyed higher yields by purchasing debt of lower creditworthy companies need not worry. When times are bad, it appears that big brother won’t let you feel the financial pain that should come with its increased risk you took. This time, it’s a bailout of company executives and company investors which comes from money that they essentially just decided to print.
Chart 3: Fed’s Credit Facilities’ Outlay
Source: Federal Reserve, Bloomberg Research
What does this mean for us investors?
The ‘free’ capital markets, as we are told they are, may be just a dream however when faced with a different set of cards, we must adapt. What we need to do is take the assumptions that we had [equilibrium of risk-reward, no price manipulation and true price discovery] and adjust our investment model based on the new, observed facts that those assumptions just don’t hold true anymore.
Even though this change is a negative one for the sanctity of the supposed free capital markets, believe it or not, this change is a positive one for investors who focus on the US. It provides investors a safety net from significant negative news and large drawdowns in the markets as the powers that be have shown recently, and during the last recession, that they are willing to step in, assume debt and print money to pay for it. This has implications for risk management as well. The Fed isn’t stepping in and taking the upside when times are good but they are stepping in when times are bad. We are now seeing skewed risk-reward payoffs. The question becomes, what is the true ‘risk’ of riskier investments. If the Fed is just going to step in and provide a floor, why would we invest in the low yielding investment grade securities anymore and why wouldn’t we leverage up our equity holdings? Thanks to big brother, companies are able to pay their debt and we are only about 10% off the equity highs despite all the economic destruction that is surrounding us – friends are being laid off, people must stand 2m apart and not interact with each other and even the pubs are closed…the pubs!
If the physical economy can be this poor and not be reflected in asset’s prices, rational traders and long-term investors will all move up along the risk curve, enjoy the higher returns in the good times and wait for a tweet from President Trump or wait for the Fed to turn their wallets upside down to stop us from financially realizing the risk we took on for which we have been getting rewarded for.
Author: Karl Rogers, founder of ACE Capital Investments, AlphaWeek Contributor, and Guest Lecturer. To find out more go to acecapitalinvestments.com
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