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- 12 ago 2020
- Tempo di lettura: 8 min

Trading during the pandemic

Introduction

Towards the end of 2019, a new virus started spreading in China and initially the international community underestimated the issue. Later, however, people realized the severity of the situation as China announced its lockdown to face the epidemic. Markets started reacting as well, with little spikes in the VIX index (CBOE’s measure of expected volatility based of SP500 options) visible already towards late January – early February.

Figure 1: VIX Index, source: CBOE

In February and March the pandemic quickly spread throughout Europe, particularly affecting Italy, France and Spain. Also, the US were severely hit by the virus during the same period.

As the number of infections rose, several countries announced lockdowns to control the spread of the virus. Market participants started to realize the impact the Sars-Cov-2 could have on the world economy. The IMF currently predicts a real GDP growth of -6.1% in the advanced economies, the outlook is negative also for emerging economies at -1%. World GDP is expected to fall by 3%. However, a strong rebound is expected in 2021 which will lead to a 4.5% predicted growth for advanced economies, 6.6% for emerging economies and 5.8% for world’s GDP.

Figure 2 Real GDP growth 2020, source IMF

Wall Street

With the announcement of lockdowns around the globe and the gloomy economic perspectives, markets reacted frantically, and panic started to spread. As a result, in March the VIX index reached a record high of more than 80 points.

Figure 3 VIX index, source: CBOE

Markets saw meaningful losses, as the SP500 officially entered bear market territory (a bull market ends when a bear market begins; a bear market is defined as a peak to trough decline of -20% or more). In early March, the circuit breaker at the New York Stock Exchange was triggered 4 times (on March 9th, 12th, 16th and. 18th). Market-Wide-Circuit-Breakers (MWCB) are a series of procedures put in place by the NYSE that may halt trading activities, usually for 15 minutes, following severe price drops. A market trading halt can be triggered at three circuit breaker thresholds that measure a decrease against the prior day’s closing price of the S&P 500 Index -- 7% (Level 1), 13% (Level 2), and 20% (Level 3), if Level 3 is reached trading activities are ended for that day. MWCB are intended to safeguard liquidity and give time to investors to gather further information before resuming trading.

Severe market declines were observed also in Europe, the Europe STOXX 600 fell by approximately 35% between February and March.

Having to face one of the worst recessions ever and a sharp market crash, central banks around the world started intervening heavily, both with liquidity injections and by cutting interest rates in the 0% area, to safeguard national economies. The FED announced rate cuts, purchasing programs up to $2T, several lending facilities and set up swap lines with major central bank around the world to support the FX market. The ECB announced the Pandemic Emergency Purchasing Program (PEPP) intended to reduce borrowing costs for government and major corporations, while keeping interest rates in the 0-to-negative territory. Thanks to CBs policies and to encouraging news on possible re-openings in major economies markets started recovering, ending the shortest bear market in history. Volatility decreased steadily from its March highs while major indexes canceled early losses. Both the Nasdaq and the SP500 are trading near their all-time highs, supported mainly by tech companies.

Figure 4 Nasdaq Composite and SP500 performance YTD, source: Nasdaq

Oil: Pandemic, Price War, WTI

The oil market not only has been affected by the spread of the virus (and the subsequent lockdowns), but also by the Saudi Arabia – Russia price war. With falling demand due to the pandemic, in March Saudi Arabia proposed a production-cut to OPEC and its allies, so as to sustain prices that were already under pressure. Russia, however, refused the deal triggering retaliation by Saudi Arabia, that increased production and offered deep discounts to buyers pushing prices even lower. Brent crude, the global benchmark, tumbled in price from almost $50 a barrel on March 5th to below $20 on April 9th. Eventually in mid-April, an agreement for a production cut was reached, and prices started a partial recovery, with Brent crude trading at around $43 a barrel in early July. The situation has been even more controversial for the West Texas Intermediate (WTI). With downward pressure from the price war and the pandemic, WTI futures for May-delivery (traded on CME group’s New York Mercantile Exchange) turned negative on April 20th. Analysts believe that this black-swan event was due to the lack of available storing space at Cushing, Oklahoma. Faced with tumbling demand, oil traders found themselves with nowhere to store the oil. The Future prices for both benchmarks can be found in the charts below (all prices are expressed in USD).

Figure 5 Brent Crude and West Texas Intermediate, generic Futures, performance YTD, source: Bloomberg

Currencies

The Covid-19 triggered – as expected – a so-called “flight to safety”. The USD, globally perceived as safe haven, appreciated against all major emerging market currencies. In addition, many emerging countries are strongly dependent on oil export, therefore the falling oil prices brought additional pressure.

The worst performer by far is the Brazilian Real (BRL), currently down more the 20% against the dollar (USD) from the start of the year. A similar pattern can be observed also for the Mexican Peso (MXN), down 13%, and other emerging market currencies, such as the South African Rand and the Turkish Lira.

Figure 6 EM coutries currencies performance YTD against USD, source: Bloomberg

As can be seen by the above chart, EM currencies display a similar pattern with lows around mid-April/early May followed by a modest rebound. The lows are probably due to the crashing oil prices brought about by the global pandemic and the tension between Saudi Arabia and Russia. The rebound, on the other hand, is probably due to the extended swap lines agreed by the FED with other major central banks to grant liquidity and calm emerging markets. Moreover, the modest recovery in the price of oil, following positive news on re-openings and the OPEC agreement, contributed to the rebound.

The Covid-19 crisis sent many emerging markets currencies into strongly undervalued territory. Assuming purchasing power parity holds (purchasing power parity, PPP, is a monetary economics theory stating that the exchange rate between two currencies is approximately equal to the ratio between the two countries’ price levels), we can use a very simple tool, The Big Mac Index, created by The Economist, to evaluate whether a currency is under-valued or over-valued. Using this tool, we can see that many emerging markets currencies, already strongly undervalued, worsen their position, this is the case of the Brazilian Real, currently 32% undervalued (it was 15% undervalued at the beginning of the year) and for the Mexican Peso, currently 61% undervalued (against 53% in January). Many practitioners believe indeed that many of these currencies are overshooting, meaning that they are displaying a value which is considerably lower than their long-run equilibrium one.

Towards the end of July, however, the dollar was affected by a major depreciation with the USD index hitting a two-year low.

Figure 7: USD index, 5-year performance, source: Bloomberg

There are two main aspects to be taken into account to explain this dynamic: the European and the American framework. In fact, the decline in the USD index is largely due to the depreciation of the greenback against the euro, which has appreciated 10% higher since May. These moves are largely due to the management of the pandemic and its economic consequences. European countries seem to be able to manage the situation, the increase in cases remains quite low almost everywhere in the continent. This in turn, allows for a “normalization” of economic activity as lockdowns have been relaxed almost everywhere.

On the other hand, the US situation seems critical, many states are struggling in containing the number cases and are being forced to re-impose lockdowns. Taking these difficulties into account, investors are expecting a new round of stimulus by fiscal and monetary authorities (many market participants believe the FED will be “easier” than other central banks). A further intervention by the FED would lead to a further depreciation of the dollar. Additionally, expectations of low growth contribute to keeping bond yields at very low levels, thus decreasing the attractiveness of treasury securities, which in turn leads to a decrease in the demand for dollars needed to buy them.

Political aspects are another major factor contributing to the recent decline of the USD and the contemporaneous rise of the Euro. In fact, while the US badly managed the situation, Europe acted successfully, containing the number of cases after relaxing lockdowns and setting up an historical recovery fund to sustain those countries worst-hit by the pandemic. Moreover, the lack of cohesion and decisiveness in the response to the global emergency and the rising of a dangerous political bipolarism contribute to putting more downward pressure on the dollar.

Rates and Gold

We are observing a confusing dynamic: two safe-haven assets moving in opposite directions, to USD is falling while the yellow metal is trading at all-time highs at more than $2000 per ounce.

Figure 8: Spot Price of Gold, 6-month performance, source: Bloomberg

The movements in the price of gold are largely explained by locking at real yields. Gloomy economic prospects are expectations of further interventions by the FED are keeping nominal yields at record lows. At the same time however, further liquidity injections by central banks are likely to trigger inflation which erodes real yields (which are defined as nominal yields net of expected inflation). The 10-year US TIPS (TIPS stands for treasury inflation-protected security, these fixed income instruments in fact pay coupons that adjust with inflation) in currently trading at about -1%, suggesting current inflation expectations of about 1.5%. Faced with the prospect of rising inflation that has pushed real yields into deep negative territory investors are looking for ways to hedge this risk and are pouring money into the yellow metal. The surge in the price of the of the precious metal, often used as a haven in times of stress, stems in part from investor demand for gold-backed exchange traded funds, holdings of which have risen to record levels. Investors stashed a net $7.4bn of cash into gold-backed exchange traded funds in July, according to data from the World Gold Council — adding to the record $40bn they invested in the first half of the year. Gold is clearly benefitting from the drop in real yields, but it is also benefitting from a weakening dollar. In fact, the metal is traded in USD, and as the value of this currency declines, it becomes cheaper to investors based outside the US.

Conclusion

The first half of 2020 has been characterized by a great market turmoil across several asset classes. Some market moves, such as yields at record lows and a strengthening USD, were expected. Others, such the incredible rebound in equity markets, were not. In particular, the Covid-19 crisis resulted in a net separation between wall street and main street, between financial markets and the real economy: while the SP500 is close to its records highs, the American economy is struggling, affected by rising inflections that limit possible re-openings and thus economic activity. Market participants agree on the fact that this detachment is probably due to the heavy interventions carry out by monetary authorities, therefore it is very hard to make predictions about what could come next. After an expected rise, the USD is surprisingly declining despite negative expectations about the general state of the world economy (usually a decline in the value of the dollar indicates confidence as investors are willing to invest in riskier assets) , adding even more complexity. The rise in uncertainty led to record low nominal yields and deeply negative real yields once inflation is factored in. Some investors start seeing the first sign of the so-called stagflation (inflation coupled with low-to-zero growth) and to hedge this risk are pouring money into gold. However, a similar bet on stagflation was made in 2008/2009, but expectations turned out to be wrong as inflation remained low during the 2010s, therefore betting on stagflation would mean betting against the current financial and monetary system.

References

Disclaimer

The ideas and opinions expressed in this report are the ones of the author and do not reflect in any way the ideas and opinions of Bocconi University. This report is intended for academic purposes only and is not intended to be an investment advice and thus should not be interpreted as such. Reliance of the information contained in this paper is at the sole discretion and risk of the reader.

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Trading during the pandemic

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