InvestInU's Three Things, February 2020 edition

Practical insights to help you break into and thrive in the investment industry

In this edition

1. Big Picture: Markets in risk-off mode amid mounting coronavirus fears
2. Let's Discuss: What an inverted yield curve means for markets
3. Soft Skill in Focus: How to disagree respectfully
4. Bonus: The Rule of 72

1. Big picture: Markets in risk-off mode amid mounting coronavirus fears

What's happening: Markets moved decisively into risk-off mode this week

• Equities down about 10% from their previous highs
• Gold at a 7-year high (all-time high experienced in 2011)
• Goverment bond yields close to all-time lows, with 10Y and 30Y Treasury yields at 1.3% and 1.8% respectively
• Yield curve has inverted again (more on that later)
• Defensive sectors (utilities, consumer staples) outperforming cyclical ones (consumer discretionary, materials)
• WTI Crude Oil dipped below $50
• VIX trading above 20

Why? Investors fear that the rapidly spreading coronavirus will dent economic growth. But since the initial virus cases appeared back in January, why are equities only correcting now? Were investors too complacent?

In the earlier stages of the outbreak, investors expected the impact to be 1) isolated (to China) and 2) transitory. Investors are now rapidly adjusting their expectations given how fast the virus is spreading globally. The market is starting to price a low but increasing probability that the virus will tip the global economy into recession through either an inflationary supply shock (closure of factories, offices, etc) or a deflationary demand shock (lower consumer spending, falling business confidence, etc). The issue is that the long-term damage to growth is almost impossible to estimate. Another concern is that central banks are ill-equipped to deal with such a shock, particularly given how low interest rates are already .

So what?

You, as an investor, can react in different ways to the sell-off:

1) If you want (or have to) keep a long-term allocation to equities, you can enter some hedges to protect your portfolio. For example, you can:

• Purchase outright protection: Buy put options on the S&P (this hedge will work well if markets continue falling but the cost of protection is high given the high level of volatility and negative carry).
• Use proxy hedges: You can buy assets that should perform well if stocks continue to sell-off. For example, you could buy government bonds, gold or the Japanese Yen. Proxy hedges tend to be cheaper than outright protection but they are exposed to basis risk (the risk that your hedge doesn't perform as well as expected).

2) Profit from second-order effects.

• Short companies most impacted by the spread of the virus (such as airlines) or you can short companies most exposed to global trade.
• Buy companies that produce face masks or pharmaceutical companies researching potential cures for the virus. Even stocks such as Netflix could do well if many people are forced to stay at home, and end up "Netflixing-and-chilling" ;)

3) You can bet on a rebound.

• Buy call options on equities (this is expensive given the high level of volatility)
• Sell volatility (potentially highly lucrative but very costly if it goes wrong)
• Buy assets that should benefit from improving sentiment, such as high beta currencies (AUD, emerging markets currencies) and commodities (oil, industrial metals)
• Short safe-haven assets such as gold, Treasuries, or the CHF. While they may display attractive risk-reward given their recent run, going against the momentum can be very costly if your views are wrong!

2. Let's discuss: What an inverted yield curve means for markets

What is an inverted yield curve?

An inverted yield curve means the yields on short-term bonds are higher than those on long-term bonds. For example, the current yield on a 3-month Treasury bill is 1.47% while a 10-year Treasury bond is only yielding 1.33%.

Is an inverted yield curve normal?

Generally, yield curves are upward sloping. Why? Imagine you lend your friend some money. You would want a higher interest rate if he promises to pay you back in 5 years than if he promises to pay you back next month. Why? 1) It is more risky to lend for 5 years; and 2) inflation could erode the value of your money. If you think about it, banks have built their entire businesses around borrowing money short-term at low interest rates (e.g. from depositors) and lending out that money at higher interest rates over longer time horizons (e.g. mortgages).

“The yield curve is generally upward sloping due to the existence of a risk premium and an inflation premium"

What does it imply?

A yield curve inversion gives us some interesting insights:

• Lenders believe there's a lower chance they'll get paid back in 1 year than in 10 years, and hence require a higher interest rate for short-term loans.
• Investors expect lower yields in the future and hence prefer to lock-in current rates for longer rather than running the risk of having to reinvest the proceeds of a short-term bond at lower yields later.
• It could also mean that investors expect lower inflation, and hence the value of their money to be worth more in the future.
• In all cases, an inversion highlights some serious concerns over the short-term health of the economy. Since bonds are publicly traded, the yield curve is a great indicator of the odds of a downturn being priced in by the market.

Why does it matter?

A 3-month/10-year yield curve inversion has predicted all 9 recessions since 1950 with a 100% success rate. In fact, the Fed dubbed it as the "best summary measure" of an economic downturn, and is typically included in econometric models that try to calculate the probability of recession. It is important to note that, historically, a downturn happened 6 to 24 months after an inversion and not immediately. And there were two occasions where the yield curve inverted but a recession never happened. Markets are good at discounting future outcomes but investors find it hard to time those outcomes. So is it time to go fully defensive in your portfolio?

The chart below shows the difference in yields between 10-year and 3-month bonds (blue line) and the probability of a recession (red line). Source: Econbrowser.com

3. Soft skills in focus: How to disagree respectfully

"You've got no clue what you're talking about you idiot, believe me I'm always right!"

Disagree, but respectfully!

Whether it's at your next assessment centre or at an important team meeting, knowing how to disagree respectfully is a skill often underestimated. Disagreeing is healthy, and is actually something that successful individuals like Ray Dalio are actively seeking (see the link below). However, the way you do it can have a strong impact on your credibility and how you are perceived by your peers. So what should you keep in mind to avoid being perceived as arrogant and close-minded?

• Start by validating the original point. Say things like "you make a good point"
• Highlight areas of agreement: "I think what you and I are saying is not that different. We both agree on ..."
• Focus on fact and avoid judgment
• Be open-minded and genuinely consider other points of view
• Use positive language
• Never lose your temper, and never make others look bad!

Ray Dalio: Seek Out Thoughtful Disagreement

https://stanford.io/2k9maE3

Now, go on and fight!

Bonus: The rule of 72

Take whatever interest rate you are receiving, divide it by 72 and – abracadabra – the result gives you an estimate of how many years you need to double your money! To double it over 10 years, you need a 7.2% interest rate. A more realistic 2%? You need 35 years. Cool, no?!

Have a great week all!

Reda & Stephane