Thursday 7 May 2020

Q&A with Peter Oertmann

The COVID19 pandemic has ignited a global economic crisis. Peter Oertmann, Chairman of the Research Committee of Inquire Europe, took some time to provide his perspective on what is unfolding.

How would you characterize the past six weeks, specifically from the perspective of a quantitative investment professional 
The last six weeks definitely have been some of the most extraordinary of my 30-year professional career as entrepreneur and investor. The Covid-19 pandemic has substantially changed the way we think and act in almost all areas of life, almost overnight. Our globally connected economy and, above all, our social coexistence as human beings have never been so comprehensively threatened. Never before have our globalized capital markets been shaken by such a massive and complex external shock.

It has indeed taken the market participants a while to understand the impact the Covid-19 virus would have on our lives. The novel respiratory disease was first reported at the end of December 2019 in the Chinese megacity of Wuhan. While the disease developed into an epidemic in China in the course of January and the WHO declared an international health emergency on 30 January 2020, the international capital markets did not yet show any signs of increased risk aversion. Around 21 February, the international stock markets were still trading at their highest levels, and the risk of the virus had not yet been priced in. This early phase is somehow reminiscent of the Titanic, when those onboard continued dancing even after the iceberg had been sighted.

Then everything changed. On 24 February, market prices for risk-bearing investments began to slide massively. On 26 February, the WHO for the first time reported more new infections outside China than inside, classified the risk as "very high" on 28 February and declared the epidemic a pandemic on 11 March. Suddenly the stock markets were grasping the news. As the economic shutdown in many countries began, the S&P 500 lost more than 30 percent, while the CBOE index for volatility of that index (VIX) soared to values around 80 percent. Equities and corporate bonds were valued globally with significantly higher risk premiums. In addition, classic “safe havens” such as US Treasuries or gold showed considerable dysfunction at times. Rising liquidity preferences of market participants led to panicky sales of all kinds of investments. It was an unprecedented scenario: market players had to price in the effects of an international shutdown of the economy for weeks or even months. In view of this major issue, the escapades around the oil price in recent weeks have almost become an anecdote on the sideline.

To prevent an immediate collapse of the system, national governments and central banks have launched rescue measures on an unprecedented scale over the past weeks. Huge financial aid packages are being provided to rescue the companies affected by the standstill. Governments are prepared to incur new debts on a large scale, and political bodies ratified the measures at record speed. The central banks are also making their mark, flooding the markets with almost unlimited liquidity, mainly through new bond purchase and credit facility programs. Figuratively speaking, the capital markets and the economy were immediately put into intensive care. 

After only a short time it became clear that the courageous action of the institutions was successful. Assets prices have recovered considerably in the course of April since the risk appetite seems to be returning. Market participants obviously believe that: firstly, the spread of the Covid-19 virus can be brought under sufficient control by the consequent measures taken by governments; secondly, the enormous government rescue packages will adequately mitigate the immediate consequences of the shutdown; thirdly, central banks will keep the risk transfer on the markets functional with their purchase programs and credit facilities. In early May the MSCI World index is only about 14 percent below its value at the beginning of the year, similar to the S&P 500. However, volatility on equity markets is still quite high with the VIX index close to 35 percent. In particular, the first-quarter company reports will continue to cause high volatility in the coming weeks, but the capital markets seem to have weathered the first shock wave of the corona pandem.

What are the differences between the crisis we are experiencing now, and that of the global financial crisis in 2008?
There are clear differences between the current crisis and the global financial crisis (GFC). The financial market crisis was opaque over a long period and was ultimately endogenous. I would like to briefly explain these two aspects, as they make the difference.

The immediate turbulence that was triggered on the capital markets during the subprime crisis and then with the event of the Lehman bankruptcy was more pronounced. Although the GFC was initially limited locally to the financial sector, it was characterized by an extremely high level of intransparency. Almost from one day to the next, the mutual trust of market participants was severely disturbed. The extreme uncertainty at the time was very well reflected for instance in the US TED spread, which is the difference between the interest rate for financing in US dollars on the Euro money market with a 3-month term and the interest rate of a 3-month US Treasury Bill. This interest rate differential reflects the prevailing confidence of market participants in the financial system and their general preference for liquidity. While this risk premium observed in the money market is well below 50 basis points in normal times, it reached values of over 400 basis points at the peak of the financial market crisis in 2008. The rapid increase of the US TED spread during the current crisis to a value of 150 basis points at the end of March was a very clear signal, but not comparable with the conditions during the GFC. 

While the GFC developed quasi endogenously in the system, the current crisis was triggered by an exogenous shock. The cause of the current crisis is thus much clearer and more understandable. That’s a big difference. It became clear relatively quickly what methods had to be used to contain the pandemic, and most governments reacted accordingly. Above all, through their behavior, people all over the world have participated in solidarity in the fight against the spread of the virus. Within a very short time, it was clear what it was all about, and confidence in a solution of the crisis could be built up. The discovery of an effective drug for the treatment of Covid-19 will further reduce the uncertainty, and the availability of a vaccine would definitely be a game changer. By and large, this crisis is nobody's fault, nobody has done anything wrong, and the cause of the crisis will definitely be effectively combated in the foreseeable future. This is certainly one reason for the rapid return of risk appetite in the capital markets, alongside the unprecedented measures taken by the institutions for economic damage limitation. 

What impact does the current COVID crisis have on long-term asset allocation and risk management for investors?
We will certainly end up in a changed world. It is already foreseeable that the current crisis will have a very deep impact on the economy, national budgets and central bank balance sheets. The IMF is expecting the deepest recession since the Great Depression in the 1930s. We all have to get through it. In addition, the pandemic will significantly change our lifestyles and consumer preferences. There is sometimes talk of a "new normality" that awaits us after the crisis, although this is currently still a kind of placeholder for framework conditions that we are not yet able to assess so precisely.

The current crisis has once again shown that a broadly diversified asset allocation offers the best protection against losses in value. In particular, classic hedges such as government bonds of the highest rating class and gold made a significant contribution to stabilizing performance. So far so good. Looking ahead, however, the future potential of all asset classes needs to be reassessed in light of the medium- and long-term impact of the Covid-19 crisis. How will our environment change? – A few guesses: Changing consumer preferences will cause certain business models to disappear and new business models to emerge. Our lives will become more digital. Deglobalization will inevitably occur, and value and supply chains will be reorganized. Following the government rescue measures, government influence will increase in certain industries, with tangible implications for shareholders. The criterion of sustainability will become even more important in investment. The exploding national debt will force central banks to keep interest rates permanently low. Shrinking capacities and higher production costs in a more deglobalized world could spark inflation and sustained low interest rates could possibly result in significantly negative real interest rates. Overall, taxes will rise, and government influence will increase.

The current crisis will therefore not only significantly change our living conditions, but also the earnings potential on the capital markets. The long-term risk premiums in equity and bond markets must be reconsidered against the background of the above-mentioned possible changes of the environment. Since real government bond yields are likely to be rather small or even negative, risk premiums in the equity markets and alternative risk premiums (e.g. illiquidity premiums, strategy premiums) could become considerably more important in the future in order to achieve long-term investment goals. It may also be a matter of integrating more investments with some inflation protection into portfolios. 

Overall, asset allocation and risk management will become more demanding and the use of powerful quantitative methods for the systematic exploitation of risk premiums in capital markets with a high dynamic of change will be indispensable. The new possibilities of machine learning from large amounts of data could help to better support investment decisions in the new environment with many unknowns. In the field of new investment technologies, Inquire Europe already supports several interesting research projects of scientist from renowned universities.     

If you had the opportunity to start a new research project today, what would the primary research question be?
I would do research on the following question: What can we learn from the Covid-19 crisis for strategic asset allocation? In the last two months, the capital markets have been under the influence of an exogenous shock on a scale never seen before. Investors were pushed into completely new territory within a very short period of time. The big picture is characterized by the fact that risk appetite initially fell sharply in the course of the crisis and then gradually increased again. It would be interesting to analyze the actions of investors in the market in detail, in order to understand more precisely the evolution of the expectations prevailing in the market and the different roles of the asset classes. The ultimate objective being to learn the characteristics of asset classes under exogenous shock from the crisis data.