Eoin Murray, Head of Investment at Hermes Investment Management, discusses the recent ‘quantmare’ which took place in June:
Ever had a recurring nightmare? Markets are having one right now.
In August 2007, a small subsection of the global markets was hit by a violent sell off that preceded the financial collapse the following year. Those who lived through this episode still bear the scars. Market neutral strategies, which formed the liquid element of many multi-strategy hedge funds that were holding piles of illiquid credit, became the go-to element for fire sale in their portfolios – the easiest stuff to liquidate was equity factor exposure (today’s systematic beta).
As they did so, all factors started moving against these market neutral funds – including the one I was running at the time. The biggest fund to be hit was Goldman Sachs' Global Alpha. It had around $12bn in assets and was several times leveraged and prompted Goldman’s chief financial officer David Viniar’s famous quote: “We were seeing things that were 25-standard deviation moves, several days in a row” (sic!). The fund closed in 2011, with a mere $1.6bn left.
In June 2018, the market experienced a similar episode, but without a Global Alpha equivalent to hit the headlines – at least not yet. Although cracks are starting to appear in the credit market, they have not reached the same fever pitch as they had by August 2007 – but neither are they far away.
Problems are beginning to stack up, and in the next 12 to 18 months or so credit markets could roll over, followed quickly by equity markets. Looking around there are plenty of drivers that could set it off – geopolitical tensions, currency wars, protectionism, to name just the most obvious.
But this time – as is the case with plenty of sequels – it is going to be many times worse.
Because we pumped so much liquidity into the system in 2008, the rubbish didn’t get carried away. All those zombie companies that in a proper recession would have been wiped out are still around. The property market is still very frothy, too, exacerbated by the obvious problems in the retail space.
The pressure has been storing up and is primed to get saucy in late 2019.
A new terrifying element to this “quantmare” will be the lack of recovery credit investors will have to face. In 2008, much of the debt was covenant-full, so there was a legal process investors could go through to get back at least some of their money. Since the crisis, more than 70% of debt that has been issued has zero or minimal covenants, so next to nothing will be recovered. The money will just disappear.
Even government bonds are primed to drop. The past 30 years is termed the Great Moderation. Yields have gone down, and prices have gone up – but there’s no more room for price appreciation.
Can we avert it? In its entirety, it might be possible, but individual elements, I don’t think so. Central banks will look to do more QE, but even they understand that its effectiveness will be less this time and realise it has to be unwound at some point. They can’t keep throwing liquidity at the problem.
What does an investor do? The worst thing you can do is panic, and you’ve seen the films: don’t go running back into where the trouble is.
Stay flexible in your asset allocation. You want to be in quite liquid instruments at this point in the cycle. Steer towards quality assets in credit and equity markets for the time being. Cash is not a bad place to be, as there will be opportunities that come out of the dislocation to take tentative steps back in with a long-term view.
It is going to be messy, but markets have to go through it. We need to clear the decks and start over. We don’t want to sleep walk into this “quantmare” again. Too apocalyptic? Maybe, but while history never repeats, it does rhyme