Round's Market Commentary
April 12, 2020
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What We Did This Week
We believe that we are in the middle of a bear market rally.
We reduced exposure to emerging market stocks and increased exposure to investment-grade bonds to further reduce unnecessary risk across Round portfolios and increased weighting towards high-quality, long-duration fixed-income assets.
Emerging markets have become an area of concern as their collective debt-to-GDP ratio has passed beyond 180%. This is a startling figure to consider, as if you were to rewind to the Asian financial crisis of 1997, the debt-to-GDP ratio was *only* 110%.
As financial stress continues to build and emerging market outflows approach $100 billion since the start of the virus, the increasing risk in this area of the market may outweigh the potential reward.
Long Duration Fixed-Income
We believe holding high-quality, long-duration fixed-income assets at this time is smart. You're being compensated more than usual for taking on a small amount of credit risk. Furthermore, the likelihood of interest rates rising is very low in the short term, because the US Federal Reserve is openly committed to keeping interest rates low until the economy has weathered the storm.
This portfolio positioning should provide an increase in income for Round portfolios for the time being, while also serving as a safe-haven until it's time to go risk-on.
What We Are Seeing
The stock market finished up this week as investors reacted favorably to an easing of death tolls in Coronavirus hot spots and the US Federal Reserve announcing additional stimulus.
While virus figures may have reached an apex in certain global hotspots, we are still only beginning to see the preliminary readings of the economic aftermath to come – a reality that many investors have not taken seriously enough this week.
For example, it was released Thursday that over 6.6 million people filed claims for unemployment benefits last week, stacking the running three-week total to approximately 16.8 million. To put this figure in perspective, 16.8 million equates to 10% of the entire US labor force, i.e., the peak of the unemployment rate during the Great Recession. Remember what happened when millions of the unemployed couldn't pay their mortgages?
The recent surge in claims has overwhelmed the operating resources of state government facilities. In Indiana, they received 65 phone calls a second at one point, and in Texas, they received a staggering 3 million calls in a single 24-hour period. This has forced some states to implement procedures such as only being able to call certain days of the week based on last name or social security number. The situation is eerily reminiscent of the oil crisis in the early '70s when you could only fill up your gas tank on certain days of the week, depending on if the last digit of your license plate was odd or even.
US Federal Reserve + ETFs
The US Federal Reserve announced an additional $2.3 trillion of emergency stimulus to help provide "as much relief and stability as we can during this period of constrained economic activity, and…help ensure that the eventual recovery is as vigorous as possible" stated by Chairman Powell.
In a historic move, the package will allow the Fed, for the first time ever, to extend their reach of purchasing investment-grade bond ETFs to now also include providing liquidity to high-yield bond ETFs.
As the Fed steps in to aggressively provide stability to the financial markets and "to forcefully get our markets working again," we are brought back to our passive ETF bubble piece from 6 months ago where we called a potential liquidity crunch in passive ETFs during a crisis:
"This [passive ETF] mania has caused saturation in specific areas of the markets, and continues to get worse as most robo advisors and many financial advisors only allocate their clients to passive ETFs.
If this herd sells their passive ETFs during a recession, it can cause sharp price declines and a serious liquidity problem.
Even if these ETF providers fire sell assets, they may still be unable to meet everyone's redemptions in a timely manner.
There can be a scenario where the Federal Reserve has to get involved and bail them out."
Cracks have already started to appear.
A few weeks ago, in one of the largest short-term maturity bond ETFs, an anonymous market maker shared that traders looking to sell more than one unit of this ETF were offered underlying bonds and not cash.
As rumors of this situation hit the street, the bond ETF sold off by as much as 34 times its largest intraday drop in 2019. Perhaps the Fed's recent entrance into the bond ETF market will help get ahead of the liquidity crunch curve – only time will tell.
We believe that back in 2019, there were many companies that earned just enough revenue to keep the lights on and barely pay back the interest payments on their debt. These "zombie" companies who just scraped by under favorable economic conditions last year, will have their revenues slashed during the ongoing Coronavirus pandemic.
Without a significant bailout, these companies will go under. Just because the Fed will buy a passive ETF that buys the high-yield bonds of these zombies, does not mean that they will survive.
To be passively investing at this time could be disastrous. Active fund managers, like the ones found in your Round portfolio, can sell out of these zombie companies that don't have a shot of surviving. At the same time, passive ETFs, and seemingly the Fed, will be the holders on the other side of these 'grenade' trades.
These are just some of the disconnects we have seen lately, and in the meantime, we will continue to hunt for mispriced, high-quality assets that will reward the long-term Round member.
See you next week!
-The Round Team