Liquidity problems and market swings: COVID-19 update for 26 March

Wednesday 25th March 2020 Justin Cleveland

Predictions around just how much damage will be done in the aftermath of the coronavirus continues to be exceptionally hard to pin down, particularly because we have no idea how widespread it will actually be.

Modelling released this week by The University of Sydney showed that the spread could be slowed significantly in Australia if 80% of the population adhere to strict social isolation protocols, curbing the spread in 13 weeks. Those same models showed that a 70% compliance rate or less would not control the spread.

While we don’t know how far the disease will spread in Australia or globally, or what ultimate impact that will have on the general economy, we are already seeing some fallout. Markets crashed, then rallied, then crashed, then rallied again. While there are reasons we can point to, such as a stimulus package being announced in the US or stricter social distancing measures being implemented in Australia, there generally isn’t a 1:1 correlation.

What is obvious, however, is that there are a lot of talented people in innovative companies trying to find ways to both limit the pain for investors and find opportunities for growth in a volatile market.

The problem with liquidity

We don't have to worry about a run on the banks (I mean, who even uses cash?)

Hard currency isn’t so much the issue as the liquidity of assets. Janus Henderson’s head of Australian fixed interests, Jay Sivapalan, says that liquidity is the key challenge post-GFC. “Banks’ ability to broker for the investment community has drastically diminished and is an unfortunate side effect of the post-GFC regulations that came into effect for banks and their trading activities.

“These developments, coupled with an exogenous shock, are almost the perfect storm that central banks and regulators feared. It is fair to say that a major contributing factor of the veracity of the market sell-off, in particular risk assets such as corporate debt, has been lacklustre liquidity and poor price discovery.”

One thing he suggests is that central banks look for ways to facilitate liquidity; a challenge that some are already fulfilling. “A number of new categories of securities have become repo eligible, meaning investors can actually sell them to the Reserve Bank of Australia (RBA) and purchase back at a later date to access near-term funding. We expect broader liquidity-focused measures to be announced in the coming weeks.”

Everyone is looking for a leader

To continue the theme of visual metaphors, it can seem like governments are trying to stick their fingers in the holes of the dam before the whole thing bursts. A little patch here, a little rate reduction there, a little lockdown over there, but not a substantive, comprehensive policy.

When leaders come out with decisive plans, the markets have responded positively, like the news that the US Senate and White House had finalised a deal. When they appear confusing, like earlier statements from the White House, the markets respond poorly.

Generally, however, there isn’t going to be a one-size-fits-all solution to the economic damage being seen. Instead, State Street’s head of policy research, EMEA, Elliot Hentov, says that governments need to act quickly and decisively to provide reassurance. The lack of decisive action to this point has been born out in the markets. “Not only will it require more time for political agreement, but the measures themselves will be relatively slow to roll out, providing actual relief to household balance sheets presumably no sooner than May. That allows multiple stresses in consumer finance to build up and worsens the overall peak-to-trough contraction in demand.”

Is this the new normal?

The economic turmoil being felt is odd because people are looking to governments for solutions when the problems themselves are being exacerbated by government action. The lockdowns, of course, are in an effort to save lives and prevent healthcare systems from being overwhelmed, causing even more complications.

State Street’s head of global macro policy research, Amlan Roy, says that modelling shows a significant crisis possible for developing countries due to emerging market capital outflows. Despite all of this, he says that the primary responsibility should be to stem the virus first. “The scale and magnitude of this crisis is likely to be much worse due to health, social care and employment ramifications. Whilst this can be concerning, we should do all we can to stem the virus spreading and try not to panic.”

It leaves us with the question, is this variability and instability our new status quo?

What makes the entire situation more difficult for investment forecasters is the ways in which traditionally safe diversification vehicles are behaving.

State Street’s head of macro strategy EMEA, Timothy Graf, says “In times of extreme market turmoil, correlations between assets often rise sharply, but exposure to safe havens like gold and the Japanese yen (JPY) can diversify away some of this risk. This is not the case today.

“Over the last two weeks, the average pairwise correlations across global equities, US investment grade credit, gold and the JPY (vs USD) have experienced a larger spike than anything seen during the 2008 crisis.”

Don’t miss the opportunities

There are, even with all of the doom and gloom, opportunities available.

Nigel Green, the chief executive and founder of deVere Group, says that every economic downturn creates a new normal. In this particular case, there are some sections of the economy that are benefitting from the fallout of the coronavirus. "Sensibly, investors are now actively seeking these ‘new world’ sectors and companies in order to grow and protect their wealth."

Big tech is one area that has had general success, as people use social networking to keep in touch in an era of social distancing. Healthcare and suppliers are another area succeeding.

Sam Twidale, Portfolio Manager at DNR Capital says the uncertainty has contributed to large swings, but investors need to remain committed to long-term planning. "Poor investment decisions are likely to be made when investors neglect their process, especially in times of elevated market stress (i.e. don’t panic). This means focusing on factors we can control, rather than the uncontrollable such as the extent and duration of the virus outbreak. Central to our investment process is to identify the highest quality smaller companies, especially those that are significantly undervalued by the market."

Twidale's advice is simple: continue to invest in high-quality companies or those that have the potential to become one in the future.

More about 1886 Consulting

Back to Insights