Twitchy resilience becomes the norm in equity markets

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Somehow, equity markets have made it to the end of the first quarter of 2021 in one piece, demonstrating bulletproof resilience to both well-understood and out-of-the-blue challenges.

The opening months of the year clearly provided nothing on the scale of the pandemic shock from the same period in 2020. Nevertheless, several mini-quakes arrived along the way. First, hordes of market novices humbled some of the sharpest minds in hedge funds in the GameStop Corp. GME-N saga.

In a more significant threat, the recent debacle with Archegos Capital Management LP, which hammered stocks in the U.S. family office’s portfolio when banks dumped them on the open market in a fire sale, left investment banks including Nomura Holdings Inc. of Japan and Credit Suisse Group AG of Switzerland nursing billions of dollars of losses.

Years from now, the Archegos affair is likely to be remembered as a big moment for speculators. Unless they actively crave the same experience as Nomura and Credit Suisse, which is unlikely, banks will almost certainly now clamp down on the speculative firepower they make available to clients, either under their own steam or under orders from regulators.

After all, as research firm TS Lombard convincingly argues, “Archegos showed the impact of forced deleveraging on financial markets.”

Although Bill Hwang’s Archegos looks like an extreme event, a rethink on leverage – in which traders used borrowed funds or derivatives to increase exposure – is likely.

“Caution is warranted,” wrote Andrea Cicione of TS Lombard. “Over the next six months, we will probably experience a period of economic expansion the likes of which have not been seen since the 1980s. Risk assets are more likely to go up than down in this environment. But ... perhaps the Archegos incident will lead investors and banks to reflect on what the appropriate level of risk-taking now is and reduce leverage accordingly.”

Perhaps. On the margins, this could certainly cool some of the frothier areas of global asset markets.

And yet, for now, the reaction in broader markets: not a whimper. Instead, the vast majority of fund managers are cracking open the popcorn to watch the engrossing fallout. Hedge fund managers are wondering when their banks might call for a chat about leverage, but right now, banks are not lifting up the drawbridges.

It is hard to imagine that such a deep risk management crisis for banks, particularly at Credit Suisse, which was also left red-faced by the Greensill Capital saga, would have left so little of a dent on markets in an earlier age. But when just about the only thing that matters to asset prices is central bank largesse – not a new feature, but intensified by the pandemic – it is hard for anything else to cut through.

Indeed, the only theme that has really left a mark this quarter is the distant risk of a withdrawal of that kind of support. Really, that is all that counts. Inflation has not yet meaningfully picked up, but the expectation that it will, particularly after the passage of U.S. President Joe Biden’s enormous fiscal support package, has been enough to produce the worst quarter for long-term U.S. government debt in four decades.

That, clearly, is bad news for holders of that debt. To a lesser extent, it has also hurt bond prices in Europe and elsewhere. But the fear that this will automatically trip up stocks has proven faulty. It turns out that you can have higher bond yields and higher stock markets after all.

“Absolutely you can have both,” says Luke Barrs, head of fundamental equity portfolio management for Europe and Asia at Goldman Sachs Asset Management LP (GSAM). For profitable companies, at least, “rates are not material to the intrinsic value of the business,” he says, especially when top-performing companies are sitting on huge piles of cash accumulated during the pandemic crisis.

Hence, the S&P 500 has gained almost 6 per cent in the quarter, rising to a record high. The tech-focused Nasdaq index has had a rockier ride, but still gained 3 per cent, again close to a record. In Europe, Germany’s Dax churned out an impressive 9 per cent gain, while the region’s banks added almost 20 per cent. That is 20 per cent from a low base, but is still not to be sniffed at.

This path has not been smooth. Climbing bond yields have posed a challenge. Expect more of that in the quarters to come. Gurpreet Gill, Mr. Barr’s fixed-income-focused colleague at GSAM, says she expects the next few months to bring “data tantrums.” Investors will struggle to interpret economic data releases in the post-pandemic era. The virus clobbered economies so badly that year-on-year data comparisons become rather meaningless.

Added to that, figuring out which companies will succeed or fail after the COVID-19 pandemic is difficult. Some lockdown winners operate on models that “maybe don’t stick” once normal life returns, says Peter Rutter, head of equities at Royal London Asset Management.

While overall stock indexes are sailing higher, sectors such as banks and factors such as value are taking the lead while others struggle. Mr. Rutter says that was one of the things making the market “quite twitchy.”

Twitchy resilience looks like the theme for the second quarter.

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