Deutsche’s Kocic On Risk Premia, ‘The Missing Variable,’ And The Elusive Post-COVID Reality

The current crisis is a shock like no other, and as such poses myriad difficulties for market participants attempting to navigate rampant uncertainty.

One common refrain is that the surge in equities off the March lows and the decline in the VIX (from 82 all the way down to 28 on Friday) is irrational considering the economic backdrop. Similarly, many argue that staking a claim on a share of assumed future cash flows and profits is an inherently absurd proposition right now considering the very real possibility that those cash flows and earnings will be significantly (and perhaps permanently) impaired.

But the truth of the matter is, nobody really knows whether a given rally (or selloff) is justified because nobody knows with any degree of certainty whether there will be a significant second (or third) wave of the virus, how long vaccine development will take, how effective any therapeutics that come along will be, what percentage of the population will even get the vaccine if it does become available, and on and on.

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“While monetary and fiscal policies operate inside the financial system, the current crisis presents an exogenous factor”, Deutsche Bank’s Aleksandar Kocic writes, in his latest note. “Exogenous shocks propagate differently through various market sectors”, he adds. “They disrupt the inner relationships that constitute the RV framework which are usually in place under normal conditions [and] as such, exogenous shocks function as ‘missing variables’ in that context”.

Kocic uses a measure of the severity of the epidemic’s spread as that “missing variable”. Specifically, he references the number of countries where the growth rate of infections (i.e., daily number of confirmed cases) is higher than 5%.

Of course, the monetary and fiscal response plays a role in determining how asset prices behave in the face of exogenous shocks.

Kocic notes that the “interaction of pandemic with policy response has created hysteresis whose shape varies across different market sectors”. Vanilla rates vol., for example, has collapsed after spiking, an apparent nod to the idea that the monetary policy response is sufficient to overwhelm some kinds fo stress engendered by the epidemic.

(Deutsche Bank)

And yet, other risk premia suggest uncertainties linger.

Although a country mile removed from its March 16 peak, the VIX is still well above its pre-crisis levels. But when plotted with the number of countries experiencing a case growth rate in excess of 5%, it appears commensurate with this particular measure of COVID propagation intensity (left pane).

(Deutsche Bank)

In IG credit, the improvement seems to have leveled off – perhaps as the market awaits the Fed’s first actual foray into corporate bonds. That’s expected any day in ETFs and should begin in individual issues shortly thereafter. Kocic also looks at 30Y- and mid-curve gamma.

Next, he flags (and illustrates) hysteresis in the interaction between various risk premia and the crisis and policy responses, in an effort to visualize the dance (if you will) between the two drivers.

For the illustrations, he employs a timeline that begins on January 23 and includes markers for  four key events: The March 3 emergency Fed meeting, the March 15 emergency meeting (which included the cut to zero and the re-launch of QE “proper”), the March 19 expansion of swap lines, and the March 23 unveiling of further emergency measures (including the corporate credit programs and open-ended QE).

Skipping directly to the color on stocks, Kocic notes that the journey of equity vol is generally similar to the pattern in 30Y and mid-curve gamma – in simpler terms, it’s “elevated relative to pre-crisis levels, but appears commensurate with the residual risks associated with the pandemic”.

(Deutsche Bank)

Kocic notes familiar discrepancies within equities, which in some cases correspond to the crisis (e.g., the extreme underperformance of energy stocks) and in others simply reflect an investor psychology conditioned by a post-GFC environment wherein equity expressions (e.g., secular growth) tethered to the “slow-flation” macro theme (and, by extension, the duration infatuation in rates) outperform, with only fleeting (albeit sometimes violent) reversals.

The real story is in credit, and as such, it’s notable that spreads remain (or have returned to) territory that reflects stress relative to the intensity of virus propagation.

Credit, Kocic notes, faces the “possibility of… additional complications in the long run”.

That’s for sure. And the credit-specific problems associated with the crisis explain why the Fed has been so aggressive in telegraphing support for the market. Over the last two months, IG issuance set back-to-back records. Keeping capital markets open is crucial at a time when cash flows will be severely impeded (and in some cases may dry up altogether) by the nature of the official response to the public health crisis.

Companies have already drawn down revolvers and the borrowing binge reflects both prudence (sandbags ahead of the hurricane, if you will) and, in some cases, desperation. Boeing is the poster child. The company’s $25 billion sale late last month arguably averted a taxpayer bailout.

The following visual utilizes the same methodology as Figure 6 above, only with IG spreads (CDX) instead of the VIX.

(Deutsche Bank)

Kocic emphasizes that credit reflects the multitude of medium- and long-term ambiguities around the post-COVID environment and the attendant ramifications for corporates.

“Long-term effects of the pandemic on aggregate demand have not been sorted out yet, especially their influence on the corporate sector and credit”, he writes, adding that the following questions as yet have no answers:

• Which businesses will survive the crisis?
• How many people will lose their jobs permanently?
• How much will they be willing to travel and consume?
• What services will they use?
• How will the banking sector respond to all of that?

For now, he says, all of that “remain[s] largely out of grasp”.

While the Fed has been effective at staving off a system-wide solvency crisis by ensuring borrowing costs didn’t balloon to prohibitive levels for all but the most sterling of corporates (and I suppose it’s possible the primary market would have shut down completely had the Fed inexplicably decided to tell corporate America to twist in the wind), there are no guarantees going forward.

“It is possible, if not likely, that despite the Fed’s protective maneuver, default rates increase, which would affect the rate of borrowing and credit spreads in general”, Kocic goes on to say. “In the near term, credit spreads could be undergoing a structural shift higher without revisiting their pre-corona levels even if the crisis subsides”.

And that reflects the broader economic concern – namely, the worry that a return to pre-COVID normality may not be in the cards. At least not for the foreseeable future.

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