ActiveAllocator portfolios are designed to be resilient to maximum draw downs- and that’s exactly how it played out for us in March. Examining markets performance in hindsight does not reveal too much for one arbitrarily selects a period to measure – random entry and exit points in an hour, day, week, month or years. Since none of us can time markets ex ante, I calculated the maximum peak to trough decline in all equity markets across the world, and in all sectors, across different time horizons. In other words the maximum amount an investor could have lost.
Anyone who had exercised a put option, or shorted these sectors with perfect foresight, would be laughing all the way to the bank today! I present the maximum sector draw down in a visual.
Russia so far has been spared rising Coronavirus infections, but that seems to be changing today with 1,836 cases reported and nine deaths. Which begs the question why have Russia and other Eastern European countries not announced plans for economic stimulus to the imminent fallout? One reason may be that sanctions have insulated Russia from global markets, unlike in 2008 where its banks were deeply entangled with the Western banking system. At that time Russia and Eastern Europe made decisive proactive interventions. This led to banking systems recovery providing the strength to fulfill their role in the economy: that of providing funding to individuals and business.
While recognizing that this crisis is nothing similar, I still think it useful to calibrate the government response at that time to provide a sense of scale – captured in this visual.
Sovereign Wealth Funds (SWFs) have lost hundreds of billions of $ ever since the Coronacrisis gathered speed. Revising Fund’s investment guidelines is vital to repairing the damage done. A wait and hold approach is hardly prudent. Such guidelines are going to be a key decision for it both flows from as well as impacts the fund’s form, governance, links between actors and the applicable law. I believe that investment guidelines should follow from the basic principles and core values of the Fund, as well as its general entrusted mission.
Sovereign Wealth Funds (SWFs) have in March 2020 alone, cumulatively lost hundreds of billions of $ in citizens accumulated wealth. Attributing this to adverse market movements is hardly an excuse. I observe that most SWFs have been on ‘auto pilot’, driven by inertia after they were formed. Meanwhile much has changed in their external and internal country environments. This naturally has ramifications on the legal framework within which such vehicles now operate, as well as their initial objectives and macroeconomic linkages with national economies. This in turn influences their investment policies and risk management frameworks. In my view the Coronacrisis should catalyze fundamental rethink of a Fund’s institutional framework and governance structure.
I believe that this is a good time for soul searching. For whether a SWF is placed under the supervision of the Ministry of Finance, or the Central Bank, or is run as an independent entity has enormous importance going forward. Something that I highlight here, as well as will build upon in subsequent postings.
Sovereign Wealth Funds (SWFs) have lost hundreds of billions of $ ever since the Coronacrisis gathered momentum, beginning March. I believe it the largest destruction of accumulated citizens wealth in history. Having advised multiple SWFs I am acutely cognizant that each has its own specificity, governance, asset allocations, risk levels and special objectives. A Fund’s institutional framework too has great influence over managers, both internal and external, and therefore has an impact on its management and returns. A SWF’s legal status also is a key decision point, since it impacts the fund’s form, governance, links between actors and the applicable law.
I am of the view that recent market events highlight the importance of managing risk holistically even more so. I draw attention to five issues in this visual.
SWFs Need to Revisit Objectives During Coronacrisis
I hold the view that nations that have already set up a Sovereign Wealth Fund (SWF) now ought to revisit every aspect – the mandate, mission statement: the very objectives of the Fund, the institutional and legal framework, the way it should manage and monitor the investment process going forward, investment guidelines that may no longer serve well, risk management/ benchmarks, the governance framework, the optimal mix between internal and external managers as well as myriad of issues including evaluation and performance assessment. Recent huge losses suffered may itself generate a public debate on topics of investment of “excess” reserves, the level of future risk and more important spill-over implication for macro-economic policies.
I believe that the more transparent and the more professional they are, the more open will be capital markets and their own citizens to their activities. We present a visual by way of catalyzing conversation.
Now that the $2 trillion coronavirus relief package has passed 96-0 in the United States Senate I am confident it will soon get through the House. The proposal includes $500 billion in loans for larger industries. I did read somewhere that one out of every five companies now is a zombie company – the walking dead, that earns just enough money to continue operating and service debt, but is unable to pay off their debt. The planned $500 billion Treasury Department fund would be subject to scrutiny via public reporting of transactions, as well as a new dedicated watchdog and accountability committee. The package won’t likely help them and I expect a rise in bankruptcies.
Here are Ten Commandments that responsible CEO/ CFOs and corporate boards may benefit from.
I had polled global central bankers in January/February – around 47 OECD and non-OECD banks participated with multiple respondents each to the survey. While the names of the banks are known (albeit concealed as I don’t have permission to reveal) the respondent profile was anonymized to ensure better disclosure. At that time I did not sense the severity of the impending Coronacrisis, so questions related to it were not asked – a mistake I feel, in retrospect.
What will happen in 2021? While governments will stand behind banks as the Coronacrisis unravels, most banks will be left in a weaker position when all this ends. Ultimately, only governments will provide the multi-stakeholder leadership, the trust and the huge balance sheet to back banks. Guan Seng Khoo, PhD and me recommend that banks need to now begin to build capital (and cut balance sheets) from recent levels, take account of an expected increasing level of loan losses, not just from problems emerging to date but from risks of a possible “ credit crunch”, likely over the course of a developing economic down-turn.
Guan Seng Khoo, PhD and me have thought through a hypothetical scenario of how the banking sector may need to restructure their balance sheets. We present our thoughts in this visual.
I am of the view that LPs prevail on their GPs to stop throwing good money after bad in their risky early stage series A/B investments, especially within FinTech. They now need start writing down investments, close down follow-on funding and institute layoffs and firm closures. The U.S. economy is expected to languish over the next two years as policy stabilization efforts are unlikely to provide a boost to financial conditions in the short term. My recession scenarios capture the potential for more crippling damage to financial inter-mediation and slower economic growth beyond the cyclical horizon. Things are going to be rough and risky early stage FinTech firms will be worst affected.
The biggest issue is GPs will disregard this advice for they have a vested interest in keeping investments going and perpetuating management fees. I had written a proprietary game ( game theory) to arrive at Nash Equilibrium in the LP-GP relationship some years ago. Some of my findings are expressed in a dated research piece, that I think is very relevant in 2020.
Historically, governments have used a variety of tools to address financial crisis and recessions with policies of either containment or resolution. For example, in 2008, government intervention moved from the provision of short-term liquidity, through distressed asset funds to medium-term guarantees to full-scale bank capital injections, nationalization and brokered rescues. Whilst the banking system seems secure in the coronacrisis, I think it is inevitable that governments will borrow from previous playbooks.
Guan Seng Khoo, PhD and me surveyed the literature on government response to previous crisis and identified three recurring responses, likely applicable in 2020 too. These being, restoring functioning markets when and if impaired, expansionary monetary policy to catalyze economic and expansion in fiscal policy to support private sector spending slowdown. We present this in a visual, highlighting recent response in 2008 for color.
Insurers are exposed to event risk from a variety of causes: Natural Catastrophes, Investment Market Disruptions and of course now, Pandemic – death claims, morbidity losses, investment losses, operations risk. Historically, many insurance firms have responded to such events by raising equity capital after the event – at depressed prices. None anticipated the specific triggering event, but all recognized the potential for tail events. I observe that all were required to raise capital at highly depressed values in order to survive, to maintain ratings or even solvency.
Before it is too late, Guan Seng Khoo, PhD and me recommend that top execs in insurance firms think out of the box and seriously consider Contingent Capital options. Contingent Capital provides guaranteed access to capital at a pre-determined price when most needed. This can supplement available capacity, enhance financial flexibility and diversify capital sources. To catalyze creative thought, we explain its potential applicability along with ramifications in this visual.
COVID-19 stimulus proposals has revived the stock buyback debate. A week later Congress continues to remain locked ( as of 3/23/2020, 8 AM EST) in acrimonious debate on details of a proposed trillion-dollar stimulus package; meanwhile these funds are critical and urgently needed. The contentious issues being prohibiting excess executive compensation and restricting corporate bailout capital injection from being used for shares buyback. While the former is intuitively obvious, the effects of the latter less so.
I support the push for a ban on share buybacks as a condition of any financial assistance. To bring clarity, we explain how share repurchases will be an egregious transfer of economic rents from the US tax payer to corporate shareholders without benefiting the economy in this visual.
As the coronavirus pandemic continues to mercilessly unfold, I recommend that large companies recognize and immediately act on significant business risks and stifled growth prospects in the months ahead. To not do so would be willful blindness. Top management in all publicly listed firms now needs to pay special attention to funding and capital structure issues, to ensure adequate liquidity, to manage cash properly and improve capital productivity. Firms should creatively avail of the spectrum of available financing options. To catalyze creative thought, I present these along with their pros and cons in a visual here.
The cost of holding high levels of foreign exchange reserves can be estimated as the difference between the interest rate paid by the central bank on domestic securities and the interest earned on foreign exchange reserves, adjusted for any exchange rate change.
Guan Seng Khoo, PhD and me are of the view that during the coronacrisis this spread is likely to change very fast. We hold the position that the close relationship between SWFs and country central banks will come under pressure, especially for the petrodollar SWFs as oil prices have tanked to less than $30. Of course not all SWFs are created equal: they lie along a spectrum of risk appetite. Those that in the past demonstrated a strong willingness to lever up and make strategic purchases, serve dual objectives of wealth creation and support of their country’s policies will now need to rethink their mandates. In order to do that, we recommend that they need to think in terms of the larger eco-system and not silo mandate, as we showcase in this visual.
A recent #ActiveAllocator survey shows that central banks rate “avoiding default” as their most important objective. That hope for serendipity is now likely over. Central banks now face heightened concern from the economic slowdown, rising deficits, currency debasing and assorted other risks.
Guan Seng Khoo, PhD and me recommend that they should further increase reserves in conjunction with greater currency and instrument diversification, and invest in new asset classes. Guan Seng has spoken extensively on the merits of indexation towards an ALM centric model, the need to arrest funding shortfalls, to monitor high levels of Surplus at Risk (SaR) as well as create a central bank liability index, interalia. His approach represents a paradigm shift away from asset, sector or horizon-driven selection and allocation. We draw attention to developing a new benchmark, by encouraging thinking through first principles in a visual here.
The need to be able to properly quantify risks, particularly those “fat tail” risks that present a special challenge to policymakers has never been more important, than in 2020. Guan Seng Khoo, PhD and me in our long careers have come to understand that transparency on risk/return and data availability allows better bench-marking and control. We feel that moving away from recognized benchmarks can help central banks achieve a better match of assets and liabilities. Internally created benchmarks can be effective in meeting safety and liquidity requirements, measuring performance and increasing accountability. All of this needs to be explicitly tied to the risk management function.
In 2020 central banks ought to consider a more active reserve management strategy; one that incorporates modern innovations in asset management which bring intensified focus on returns. While counter intuitive perhaps to conservative central banking mindset, Guan Seng Khoo, PhD and me recommend a gradual expansion of the range of credit and duration of instruments held. We also suggest hedges to key risks, including commodity risks as well as consideration towards agency paper and investment tranches of collateralize mortgage securities supported with more active currency positioning and securities lending. Their FX policies should be geared towards paying greater attention to boosting market confidence in the context of float/managed float. We further feel moving away from recognized benchmarks can achieve a better match of assets and liabilities. Internally created benchmarks can be effective in meeting safety and liquidity requirements, measuring performance and increasing accountability.
Here is a synthesis of what folks seem to be talking about on Coronavirus, economy etc.. Not all of these are my own thoughts, but rather is a summary of a general consensus emerging, that hopefully provides added perspective
Life insurers in multiple companies, in multiple countries are now being downgraded by rating agencies. Things have suddenly gotten a lot more serious than what I had warned likely two weeks ago. I now believe that optimizing firm’s capital, including building reserves needs to go to the next step: Insurers sitting on unrealized value on their balance sheets should start monetizing before it is too late. Guan Seng Khoo, PhD and me, after much deliberation, point out in the visual below, that on balance, the pros of such decision now out-weigh the cons
#ActiveAllocator has been prescient in advising that top management in insurance companies begin beefing up their firm capital, reduce both asset and liability risk to optimize their capital structure. True to form, Fitch Ratings and other agencies have this week begun revising the rating outlook for life insurance industries to negative from stable. The outlook revision is due to increased concerns over the Coronavirus and related impacts on credit quality. Guan Seng Khoo, PhD and I will continue to make appropriate recommendations for the insurance industry in coming days. For those of you who may have missed our earlier recos here they are again.
Pandemic Emergency Purchase Program will have an overall envelope of €750 billion and will buy government and corporate bonds. Complements big bank stimulus package. Eases collateral standards and removes self imposed restrictions on purchases. Details awaited. Measures surpass 2008 crisis response as described below.
That we are very likely in a recession already, awaiting NBER decision, is a given. Whether this will lead to a full blown financial crisis is the real question. Since no two financial crisis are alike Guan Seng Khoo, PhD and me examined the previous 3 recessions to tease leading signals. While not a scientific study, perhaps biased with sampling error and some data mining, we note 4 common characteristics that we should keep an eye out for : (I) poor equity market performance, (II) elevated volatility, (III) a decline in commodity prices and (IV) increased short-term bank funding and long-term capital costs. We capture this in a visual to illustrate.
Chancellor Rishi Sunak in the #UK is soon going to reveal additional details on a massive corona economic stimulus package – around £350 bn. It will include £330 bn of business loan guarantees. Includes aid to cover a business rates holiday and grants for retailers and pubs. Help for airlines is being considered. Provides increased access to government-backed loan or credit on attractive terms. Mortgage lenders will offer a three-month mortgage holiday. This is taking shape right now (3/18/2020, 10 AM EST). Guan Seng Khoo, PhD and me visited the actions UK government took in 2008 and find those to be very comparable in size and boldness. Here is a visual we put together of actions taken in 2008 by way of quick contrast.
As one who experienced the 2008 crisis first hand on Wall Street, as both front row observer and participant, I been reflecting: It was very different from what’s happening now. It was a banking crisis that unfolded slowly over a year. Interest rates were high and the Fed had a lot of latitude to act, and it did so decisively. The government response too was purposive, proactive and coordinated with policies of either containment or resolution. Government intervention also moved from the provision of short-term liquidity, through distressed asset funds to medium-term guarantees to full-scale bank capital injections, Nationalization and brokered rescues. For those of us who may have forgotten that horrid year, I present the sequence of events as they unfolded, in this visual.
Today’s NY Times on page A14 says ” (Treasure Secretary) Mnuchin Wants Federal Crisis Powers to Be Restored”. It suggests we expect a widespread economic downturn, the likes of 2008, to be countered with the crisis era playbook. I examined financial crisis over the last 3 decades and was quite unable to come up with common root causes that trigger these events – necessitating different tools each time . Here is a visual I came up with that hopefully speaks to this.
Optimizing insurance firm capital during increased systemic risk is challenging. I recommend that proactive savvy execs use economic capital measures determined for each business and investment category, to optimize (minimize) required capital to meet return targets.
Given the likely very adverse impact of the unfolding pandemic, I recommend that insurance company execs start seriously reducing their asset risk. In my view, the pros of such a decision in this environment far out-weigh the cons.
Federal Reserve has just cut interest rates to Zero – great opportunity for the US to issue new/ re-finance debt at zero cost. I recommend that insurance company top execs too take cue and start proactively revisiting, restructuring and reducing their liabilities. De-risking the asset side of the business clearly ain’t gonna be enough. Restructuring liabilities pros outweigh the cons in this environment, as I show in the visual