I am taking this opportunity to share whatever insights I have gleaned thus far from the spread of the Coronavirus and its attendant impacts upon market risk.
I must begin by disclaiming any specific knowledge of either the trajectory of infectious diseases in general or of the ultimate outcomes of this particular outbreak.
Moreover, and at the risk of stating the obvious, market impacts are unknowable absent an understanding of how this episode plays out.
Published reports suggest an extraordinary range of potential outcomes, and it would be wise to discount the extreme ones at both ends of the spectrum.
Market Synopsis:
What we do know, from a market perspective, is that events to date have catalyzed:
- A high-single-digit or greater drawdown in equity indices.
- A massive risk reallocation – primarily into global Treasuries but also into other “defensive” risk factors such as Gold.
- A huge spike in volatility measures, with benchmarks such as the VIX doubling within a handful of sessions.
There’s absolutely more to the story, but these are the key elements on which I am focusing.
Economic Implications:
Not much visibility here, but there’s a near certainty that even what has transpired thus far will have taken a significant bite out of 2020 Global GDP, and that the more the virus spreads, the bigger the reduction will be.
It is also a hard to dispute the reality that governments and central banks in major jurisdictions will counter the financial/economic carnage with massive monetary and fiscal stimulus.
Risk Management Implications:
Generally speaking, NO ONE has an edge here – of any kind. Perhaps there are a few unicorns out there who have some degree of certainty that the virus will either run its course or evolve into a pandemic. These individuals and entities are on their own, and neither need nor want any help from me.
For the rest of us, it is wise, I believe, to be reactive – carefully parse the information overflow, and make judgements based upon the most informed assessments you can muster. And only effect portfolio adjustments based upon a totality of factors that extend beyond Corona. Information, of widely divergent degrees of accuracy, is flooding in in contemporaneous time. It’s best, I think, to ignore the most overwrought of these reports as noise.
My best advice is to stay the portfolio course, while shading to the defensive. Just as the timing is sub-optimal to load the risk boat, it is equally dubious to undertake a wholesale reduction of portfolio risk. Neither approach presents risk/reward tradeoffs that are particularly favorable.
Instead, I’d play it a little on the tight side here, while protecting core positions.
A few other risk management notes:
- At this moment, the markets are rallying back. Historically, this is a sign that the risk premium rise has yet to run its course.
- On a related note, high-volatility corrections do not historically end until the volatility dissipates.
- My assumption is that the episode will run its course, and that current conditions represent a buying opportunity. If so, it will be better to buy on the way up; not on the way down.
- If, on the other hand, you see bargains too compelling to resist, then understand you should anticipate enduring uncomfortable volatility on your path towards monetization.
- I would protect your core positions as a top priority. This being stated, and with respect to other risk reduction options, my thoughts are as follows:
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- Long Treasury positions remain the ideal offset to equity exposures, record low yields notwithstanding. If the virus spreads to our shores in critical mass, long-term US rates will go negative.
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- By contrast, it is absolutely the wrong time to buy index options and other long volatility products. They are overpriced here, and the fact that the sell-side is in full-on pitch of these instruments at the moment, you should avoid them.
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- If you MUST own vol here, please consider doing so in spread (e.g. collar, straddle, strangle) configuration.
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- I’d go so far as to suggest that short vol positions – particularly writing covered calls, is a much more effective strategy.
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- In terms of direct portfolio risk reduction (always my preferred method), I’d begin by cutting non-core positions, and then, as necessary, trimming key holdings.
Overall, unless Corona kills us all, my sense is that this will pass, and the markets will resume their upward trajectory. There is still a shortage of investible securities out there, and it’s growing. The custodians of big capital pools know this, and my guess is that they are making plans to increase their holdings share – as enabled by what are certain to be even lower borrowing costs than the prevailing microscopic levels.
But us mere mortals must be more careful. Manage this day by day. Minute by minute.