Insights

We regularly publish our assessments of the current situation in the global financial markets, detailed analyses of our investment strategies and technical articles on machine learning in quantitative asset management.

Market Insights

21 April 2020 Capital markets are beginning to trade the "new normality" and can obviously gain something from it

The capital markets generally look very far into the future without emotions. Otherwise - in view of the daily abundance of news about the human tragedy of the corona pandemic and the consistently very negative forecasts for the global economy - the relative stability on the stock markets or even the positive development of prices over the past two weeks could not be explained.

In our Market Insight of March 30, we had worked out that, for the time being, risk appetite on the capital market and thus demand for risky investments will be mainly influenced by the extent to which the global community and the relevant institutions are able, firstly, to manage the dynamics of the corona infection curve, secondly, the solvency of companies in this phase of widespread economic shut-down, and thirdly, the functionality of the markets.

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Currently, market participants are obviously assuming that the spread of the corona virus can be brought under sufficient control by the consistent measures taken by governments, that the enormous rescue packages of the states will adequately mitigate the immediate consequences of the shutdown and that the central banks will keep the risk transfer on the markets functional with their purchase programs and credit facilities. The global market index MSCI World has already risen by more than 20 percent since its low at the summit of uncertainty about the course of the pandemic on March 23. The American stock index S&P 500 has even gained more than 25 percent in the same period. However, volatility on the equity markets is still very high, with the CBOE index for volatility of the S&P 500 (VIX) still at 40 percent, which is about twice as high as in normal times. In particular, the first-quarter company reports will continue to cause high volatility in the coming weeks, but the capital markets seem to have weathered the first shock wave of the corona pandemic.

Progress in the three fields mentioned above - infection dynamics, corporate solvency, market functionality - is reassessed daily on the capital market, especially with regard to the possible medium and long-term economic consequences. Leading institutes expect a drastic slump in global economic activity. The IMF is expecting the deepest recession since the Great Depression in the 1930s - in concrete terms, the global economic growth forecast has been lowered from the original plus 3.3 percent to minus 3 percent. There has never been such a significant revision of expectations. Nor has such a sharp decline in the global economy ever been expected before. The evolution of economic data these days clearly shows the way into this recession. In recent weeks alone, more than 22 million people have lost their jobs in the US.

Investors are well aware of these figures and projections. Nevertheless, the dramatic developments in economic data and the gloomy forecasts do not appear to overly impress the risk appetite on the capital market at present. Some technical market analysts classify current market dynamics as a "bear market rally" expressing their assumption that we see an interim recovery of prices in a sustained bear market. However, technical market classifications have no usable economic substance. We assume that the prices on the capital market reflect investors' expectations and that the positive market development of recent weeks is indeed linked to a well-founded assessment of the medium to long-term effects of the corona pandemic. There is strong evidence that the situation is calming down, especially in the interest rate markets. As in the last Market Insight, we analyze the US TED Spread, the US Credit Spread and the US TERM Spread as traded indicators of market participants' risk appetite.

The US TED (Treasury-Eurodollar) spread, the difference between the interest rate for US dollar financing in the Euro money market with a 3-months term and the interest rate of a US Treasury Bill with a 90-day term, serves as a proxy for the prevailing confidence of market participants in the financial system and their general liquidity preference. The deep market uncertainty in the course of March caused the TED spread to jump from 0.07 to around 1.51 percent. This level was last reached in the financial market crisis of 2008. The immediate and comprehensive measures taken by the major central banks to provide almost unlimited liquidity were able to calm the situation, as the TED spread has since returned significantly to a value of 1.02 percent (on April 17).

The US credit spread also points to the development of new confidence in the financial strength of companies after the pandemic shock. The difference between the interest rate on US corporate bonds in the BAA credit rating class (medium-quality debtors) and the interest rate on US Treasuries, which have the highest rating, rose from 2.4 to 4.3 percent in the course of March. This is because the corona virus has also directly caused serious doubts about the health of companies. However, this spread has also narrowed again in recent weeks to a value of 3.25 per cent (on April 17), which indicates that investors are evidently having confidence in the scale and effect of the rescue packages.

Finally, we look at the US TERM spread, specifically the difference between the interest rates on US Treasuries with 10 years to maturity and those with 3 months to maturity. A widening spread between these rates due to a rising yield curve indicates positive economic expectations, while a narrowing spread due to a flattening of the curve is associated with recessionary trends or a recession. In February, the corona pandemic hit an already very flat US yield curve, i.e. certain expectations of recession had been in play in the US for some time. The two interest rate cuts by the US FED in March and the other measures have turned the yield curve around somewhat and caused the TERM spread to climb to a value of 1.16 percent. However, the effect of the actions has since weakened somewhat, with the spread currently standing at 0.50 percent (on April 17). In other words, the recessive tendencies cannot be eliminated even with the FED's heaviest guns.

Conclusion: The daily news is rather unpleasant. Above all, the short-term economic expectations are gloomy. However, both the observation of asset prices in recent weeks and the analysis of interest rate structures show that investor confidence in the market is slowly coming back. Market participants believe in the effect of the extensive measures taken by governments and institutions and assume that after a severe recession, strong catch-up effects will immediately boost the economy again. The IMF is already forecasting global economic growth of almost 6 percent for 2021. We will then probably be in a world with changed conditions and preferences. The capital markets are already dealing with this "new normality" and can apparently gain something from it.

30 March 2020 Some confidence is sprouting because the big institutions act courageously, and medicine achieves top performance

These days, our thoughts and conversations almost exclusively revolve around the immediate impact of the corona pandemic on our personal lives, on society and on our future after the crisis. The human tragedy of the pandemic is bitterly brought home to us by the various platforms and the daily stream of news on all conceivable channels. The economic consequences are immediately felt due to the serious measures that have been taken in many countries to achieve effective social distancing. And it doesn't take much imagination to conceive the medium and long-term effects on the economy and thus our livelihoods. It is already foreseeable that the economic damage will be immense. Nevertheless, the current measures are indispensable. The first priority now is to save human lives. We must work together to slow down the spread of the Covid-19 virus. Only then will our health systems have the chance to help all people critically infected by the virus, to prepare for larger numbers of patients and to develop therapies to mitigate the course of the disease. The consistent shutdown of public life is the indispensable first step in overcoming the most serious crisis since the Second World War.

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On the one hand, it is now necessary to protect human life directly. On the other hand, we must not lose sight of the fact that maintaining economic activity is also an indispensable basis for the sustainable health of people and peaceful coexistence in our society. Under the current, necessary restrictions, substantial parts of the economy have come to a standstill. Some sectors are particularly hard hit, e.g. the travel industry: when no one is allowed to travel, airplanes remain on the ground and hotels are closed. Trade fairs and congresses are being cancelled in series. Higher-value consumer goods are not bought and investment decisions in companies are postponed. People fear unemployment and look to the future with great concern. Many companies, especially medium-sized companies, will certainly not survive the crisis on their own. Never before has there been so much uncertainty about future economic development.

The capital markets have had five extremely turbulent weeks. With extraordinarily high volatilities, massive price slumps in risk-bearing investments were observed around the globe. In particular, equities and corporate bonds were valued at significantly higher risk premiums, which led to sharp price falls in the corresponding markets. The classic "safe havens" such as US Treasuries or gold showed considerable malfunctions at times. Rising liquidity preferences of market participants led to panic selling of investments of all kinds. Never before capital market players had to price in the effects of an international shutdown of the economy for weeks or even months.

In order to prevent an immediate collapse of the system, national governments and central banks have initiated rescue measures on an unprecedented scale over the past four weeks. Huge financial aid packages are being made available to rescue the companies affected by the shutdown. In return, the states are prepared to incur new debts on a large scale. All this is going through parliaments at record speed. The central banks are also setting their mark, flooding the markets with almost unlimited liquidity, mainly through their new bond purchase programs. In comparison, the quantitative easing during the last financial crisis looks more like a mere exercise in easing. The economy and capital markets have been in intensive care for a few weeks now.

Certainly, it is also the courageous actions of the institutions that have brightened the mood on the capital markets somewhat in recent trading days. The global stock market index MSCI World is still almost 20 percent below its value at the beginning of the year and the CBOE index for volatility of the S&P 500 (VIX) is drifting around 60 percent. However, the strong selling pressure on the equity markets with successive, very negative daily returns - the downward spiral of share prices worldwide - seems to have been broken somewhat. Obviously, the risk appetite of market participants is rising again these days, and a small "seed of confidence" is sprouting from the ground.

The mood on the capital market is currently and until further notice dependent on news from three areas. These are three challenges that must be managed by the global community in a very short- term, very determined and very successful manner. Developments in these areas are nourishing the confidence that is growing in these days. Sustainable successes will certainly have a positive impact on investors' risk appetite:

  1. Management of the infection dynamics: If it becomes clearer that the global community is capable of containing the immediate rapid spread of the virus in order to maintain and strengthen the functioning of health systems, as described above, investor confidence will increase. Although the number of cases of corona infections is still rising rapidly worldwide, the momentum seems to be slowing down somewhat. Mathematically speaking the second derivative of the infection growth curve seems to tend towards the negative value range. The massive restriction of contacts between people, the social distancing enforced in almost all countries proves the determined and consistent action of governments to avoid an even greater human tragedy. The development of prices on the stock markets and also of corporate bonds over the last few days indicates that market participants are beginning to build up a certain amount of confidence in these measures. Further good news about the effect of the measures, accompanied by a clearly visible flattening of the curve, as well as progress in the medical management of the crisis, is expected to further stabilize the capital markets.

  2. Management of corporate solvency: The far-reaching standstill of the economy leads many companies, especially small and medium-sized enterprises, into insolvency in the short term. Governments have understood that they must support companies and freelancers with liquidity, credit guarantees, loans and simplified access to state services. They are doing this, and they are doing it boldly. The United States provides two trillion US dollars in aid. The German federal government's rescue package of around 750 billion euro is the largest in the world relative to the country's gross national product. Similar packages are being put together in all countries. The crucial thing now is that this money for maintaining the economy and future purchasing power reaches where it is urgently needed very quickly and without formalities. Good news about the successful implementation of these programs will further stabilize investor confidence.

  3. Management of market functionality: In recent weeks, market distortions have been observed at times, which have indicated panic-like behavior by market participants. These were the days when the prices of all securities and precious metals suddenly slipped due to massively increased liquidity preferences or when trading in US Treasuries was disrupted. Only the central banks can manage this issue. They do, and just like governments, they do it courageously. The FED, the ECB and other leading central banks are executing drastic measures on an unprecedented scale, flooding the markets with liquidity on a daily basis. Although it is still largely unclear what this enormous market liquidity and the explosive growth in central banks' balance sheets will do to us in the medium and long term, these measures are essential as a ‘hygiene factor’ in the current situation. If this prevents market disruptions in the near future, it will further stabilize the risk appetite of the players.

The global recession will come, that's for sure. The extent of this recession is difficult to assess at present, because there has never been a global crisis that directly affects everyone in their lives. It is also difficult to estimate how much of it the markets have already priced in. As all information is available, current prices should largely reflect prevailing expectations. As already mentioned, some confidence is just beginning to emerge. This may turn around very quickly if the situation in the three areas changes. The markets will remain highly volatile.

Since the capital markets are known to look very far into the future and the expectations of the aggregate of market participants are traded there, it is worthwhile to analyze selected, scientifically sound information carriers on the capital markets in addition to the daily news flow on the corona crisis. Above all, interest rates and interest rate differentials are important indicators of the expectations and risk appetite of market participants. In the current situation, we are observing three interest rate differentials very closely; these are shown graphically in the appendix. New developments in the above three areas will be directly reflected in them.

  1. US TED (Treasury-Eurodollar) spread: The difference between the interest rate for US dollar-denominated financing in the euro money market with a 3-month maturity and the interest rate of a US Treasury Bill with a 90-day maturity reflects the prevailing confidence of market participants in the financial system and their general preference for liquidity. Specifically, the TED spread captures the interest rate premium for the counterparty risk of banks operating in the euro money market. Over the past 10 years, this spread has mostly been at levels between 0.1 and 0.5 percent due to the highly expansive policies of central banks. However, since the beginning of March we have seen a rapid widening of the spread from 0.07 percent to 1.31 percent today. Market participants' confidence in banks and the financial system in general has thus deteriorated sharply and massively since the outbreak of the corona pandemic. The further course of the TED spread will provide us with information on the stability of the financial system, and will show us whether the measures taken by central banks are actually sufficient.

  2. US credit spread: The difference between the interest rate on US corporate bonds in the BAA credit rating category (medium-rated borrowers) and the interest rate on US Treasuries, which have the highest credit rating, reflects market participants' confidence in the financial strength of companies. In the course of March, this spread has risen from 2.38 percent to 4.16 percent today. Investors are much more critical of the solvency of companies than they were a few weeks ago. The further development of the credit spread will provide us with information on the state of health of companies and will show whether the fiscal rescue packages of the states are finding traction in their implementation.

  3. US TERM spread: The shape of the yield curve reflects the traded expectations of market participants regarding economic development. A steep yield curve indicates positive economic expectations, while a flattening of the curve is often accompanied by recessionary tendencies or a recession. The US TERM spread (10Y-3M), i.e. the difference between the interest rates on US Treasuries with a 10-year maturity and those with a 3-month maturity, has tended to fall sharply over the past 5 years, and was negative on several occasions in 2019. It was also negative in February of this year when the corona pandemic became apparent. The systematically shrinking and at times negative US TERM spread is a reliable indicator that certain expectations of a recession have been in play in the USA for some time. The two interest rate cuts by the Federal Reserve on March 3rd by 0.5 percent in the range from 1.00 to 1.25 percent and on March 15th by a further 1.0 percent in the range from 0.00 to 0.25 percent have turned the yield curve somewhat around and made the US TERM spread slightly positive; the current value is 0.87 percent. In the end, the FED's massive measures have stunned the bond markets for the time being. The further course of the US TERM spread will show us the economic trends in the most important national economy.

These indicators, in addition to other macroeconomic variables and fundamental criteria, are also incorporated into our ML algorithms and are partly responsible, in particular, for the equity exposure in the portfolios. In the coming weeks we will come back to these three interest rate differentials again and try to classify the developments.

It is now the time of the big institutions and of all those who perform at the highest level in medical care and research every day. But we ourselves can also do something! We can help other people and contribute to securing our economic livelihoods if we now stay at home in a disciplined manner and act in solidarity. We must not lose our optimism!

16 March 2020 The capital markets will remain in "risk-off plus" mode - until the second derivative becomes negative!

In the last two weeks our lives have changed substantially. The government measures to slow down the spread of the Covid-19 virus have slowed down our lives in an unprecedented way, almost brought them to a standstill. Companies around the world are in business continuity management. Business trips are cancelled, and where possible, teams are split and moved to home offices. People buy food - sometimes in huge quantities - and otherwise practically stop their consumption. Private trips are cancelled and all plans are put on hold for the time being. The cities are orphaned, and in some places there are already explicit curfews. Borders are closed, freedom of movement is increasingly restricted. The news and social media are full of reports on the spread of the virus, infection rates and measures taken in the regions and countries.

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All this depresses the mood, and most - even those who cannot remember the model of exponential growth from their mathematics lessons - have now understood: These limitations must now be the case! As a society, we must now manage, in an act of solidarity, to contain the speed at which the virus spreads, so that our health systems remain functional. We must do everything in our power to push down the growth curve of infections; growth must flatten out. Mathematically speaking, the second derivative of this curve must become negative. Only then will the dynamics of infections among people weaken. The world community must concentrate on one issue: Flatten the curve!

As a result of this dramatic development, stock markets have slumped massively in the last three weeks. The MSCI World has lost about a quarter of its value since mid-February, while investors worldwide have fled to safe havens such as US government bonds (up about 8 percent) and gold. The CBOE volatility index for the S&P 500 (VIX) has risen from relaxed levels by about 15 percent since mid-February to levels of 60 percent and more. The capital markets are in an alarming mood. The current daily movements in major stock indices such as the Dow Jones Index are at historic record levels. The actions of market participants reflect the highest degree of uncertainty about the future global economic order, economic development and above all the coexistence of people in this world.

The fears and measures taken in connection with the corona virus are already leaving deep scars on the business operations of companies. Due to massive sales slumps, a large number of companies in some industries are already on the brink of collapse. The medium-term outlook is darkening for almost all industries, with only a few exceptions. All of this is probably already largely reflected in prices. The daily ups and downs are currently determined by new information on the spread of the virus and the assessments and measures taken by global institutions, governments and central banks. The current oil price war between Saudi Arabia and Russia is almost becoming an anecdote against the backdrop of the Covid-19 threat.

The first reactive interest rate cuts by the central banks have evaporated rather quickly on the markets. When has there ever been a time when the FED cut the key interest rate by an extraordinary 0.5 percent and the markets just batted an eyelid? The market participants understood very quickly that monetary policy cannot do much, or at least not much any more. The ECB in particular lacks the powder that could be shot to stabilize economic momentum. Nevertheless, a few days ago the ECB once again massively improved financing conditions in the euro zone by purchasing additional bonds and lending to banks. At the same time, President Christine Lagarde very clearly called on governments to take the lead in combating the crisis with fiscal means. The finger is pointing in the right direction. Nevertheless, the central banks must continue to take care of the hygiene factor of liquidity, which they will do without any limit. Yesterday, Sunday, in a second emergency meeting, the FED lowered the key interest rate again by 1.0 percent, anchoring it close to zero. Unfortunately, there is only one interpretation for this: the dynamics of the virus spread in the USA and the economy seem to be in a very bad state at the moment.

The massive real economic shock can and must be fought by the states. Many states have already reacted with enormous aid commitments to companies. The German government has announced that it will do "everything necessary" to support companies in this situation. Measures amounting to half a trillion euros are on the table. Aid packages worth billions have been made available worldwide. Presumably it was these latest pledges by the heads of state that saved the stock markets from even bigger crashes. Now it is important that the stabilising effect of these aid packages and funds actually materialises.

The economic risks of the pandemic are immense. China has just published catastrophic growth figures for January and February: Industrial production plummeted by 13.5 percent and consumption fell by 20 percent. Have there ever been such figures from China? A global recession is very likely. The economic development in the USA appears extremely critical, as the yield curve in America has been pointing to considerable recessionary risks for some time.

The mix of market movements, relative valuations and the emerging economic data is complex. The currently dominant factor in the markets is the risk appetite of the players. This is reflected in their portfolio decisions and is derived primarily from their assessments of the economic and social consequences of the corona spread. At present, one could speak of "risk-off plus". Classical fundamental valuation and selection processes are outshone by this. For the capital market to regain confidence, good news is needed in the following three areas:

  1. dynamics of the spread: The considerable measures taken by governments to achieve social distancing must have a measurable effect. The exponential growth curve for the spread of the virus must change into a logistic curve - as explained above: the second derivative of the curve must become negative! This must be evident in many countries, global progress must be visible. Good news about the curve should make investors more confident and willing to take risks.

  2. Knowledge about the virus: The virus must become more transparent for us humans. If medical research and practice gains further knowledge about the properties of Covid-19 that will make us safer in dealing with the virus, this will have a positive effect on market sentiment. Every silver lining on the horizon in the medical sector can lead to enormous price corrections - upwards.

  3. State of health of the companies: It must be noticeable that the numerous fiscal aid packages are actually sufficient in volume and are distributed boldly and unbureaucratically. If companies can actually stabilise with this aid and we receive positive news from the strongly affected sectors, this will increase the willingness to take risks on the capital market.

We are all responsible for topic 1. Topic 2 is in the hands of doctors and medical researchers, and topic 3 is now in the hands of politicians.

There will definitely be life after the crisis. The virus will then still be in the world, but will have become a part of our reality. Then people will live together again, work, consume, fulfil their dreams and make plans. The vast majority of business models will still work after the crisis. There will of course be deep marks on companies' balance sheets, and some production and supply chains will change. But it will continue. The courageous actions of states and institutions and the solidarity and discipline of the people will lead us through the crisis.

Of course, there are also extraordinary opportunities on the capital market at present. As a result of the distortions, risk premiums have risen massively, especially in the stock markets and for corporate bonds, i.e. the expected returns are particularly high. Even those who are currently prepared to buy illiquid investments can expect higher risk premiums than usual. Speculative funds could be invested accordingly if the risk-bearing capacity is sufficient. In this environment, there is only one recipe for investment: diversification. Only consistent diversification across stock and bond markets, across regions, countries and currency areas, as well as across different investment styles and risk premiums, is able to bring assets over the rigours of this natural catastrophe.