Daily Comment (June 1, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Good morning.  It’s Monday and the beginning of another month.  Global equities are mixed this morning, although we do note the Hang Seng rallied.  Over the weekend, civil disorder occurred around the U.S.  We discuss the latest with China.  The G-7 was cancelled.  As usual, we update everything we know about COVID-19.  Let’s get to it…

Civil unrest:  In the wake of the death of George Floyd, protests and violence occurred in numerous U.S. cities.  For the most part, financial markets are generally unaffected by these sorts of events, mostly because they don’t last long.  That isn’t to say they are not having an effect on the economyRetailers are being forced to close stores.  We also note the protests are undermining America’s credibility in reference to human rights; China is pointing this out with reference to Hong Kong.  However, overall, equity markets are not showing much effect.

China:  On Friday, as expected, President Trump unveiled U.S. policy with regard to Hong Kong.  Equities rallied, which suggests financial markets were expecting much harsher policy actions.  Still, it is unmistakable that relations are deteriorating and are expanding beyond trade.  At the same time, the EU is making it abundantly clear that it won’t take any steps to jeopardize trade relations.  For the first time in three decades, security officials in Hong Kong have banned the usual Tiananmen Square Massacre vigil, normally held on June 4.  They have cited pandemic issues, but few believe that is the primary concern.  Additionally, Beijing has told its state-run commodity firms to “pause” the purchases of U.S. agriculture products.  If this persists, it will put doubt into the Phase 1 trade deal.

Foreign news:  After German Chancellor Merkel indicated she would not travel to Camp David for the G-7 summit, President Trump decided to postpone the entire affair until autumn.  He has indicated he would like to invite Russia, South Korea and Australia to the meeting to discuss how the world should deal with China in the future.

COVID-19:  The number of reported cases is 6,193,548 with 372,479 deaths and 2,656,267 recoveries.  In the U.S., there are 1,790,191 confirmed cases with 104,383 deaths and 444,758 recoveries.  For those who like to keep score at home, the FT has created a nifty interactive chart that allows one to compare cases and fatalities between nations, scaled by population.

Policy news: The next big worry for the financial markets is state and local governments.  As revenues crater and virus-related spending soars, cities and states are facing the problem of either increasing borrowing or cutting services.  In 2010, local governments cut back spending to the point where it more than offset federal spending.  If that is repeated, it increases the threat of an economic relapse.  The alternative may be either direct fiscal support from the federal government, or expanding Fed buying of municipal debt.

Finance news:  We are paying close attention to the dollar’s recent slide.  There are likely two factors behind the weakness.  First, as the world economy recovers, flight-to-safety demand for the greenback is likely easing.  Second, the EU’s decision to create a Eurobond for virus spending relief could bring more potent competition for the dollar’s reserve role.  We have serious doubts that the northern European nations will allow this decision to evolve into a general spending Eurobond, but the hope has lifted sentiment toward the EUR.

Economy news:  As we have noted in the WEU, gasoline consumption does appear to be recovering.  GPS requests are rising as well.  An increase in driving activity bodes well for economic recovery.

  • As noted below, global PMI data is showing signs of improvement from a deep trough. However, China’s PMI data, although in expansion mode, is showing few signs of acceleration.
  • It does appear that meat processing has recovered; however, in a pattern often seen, meat prices will likely remain elevated for a few weeks as grocers take advantage of improving margins.

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Asset Allocation Weekly (May 29, 2020)

by Asset Allocation Committee

The recent strong rally in equities has befuddled investors—how can equities rally with such vigor when the economy is historically weak?  We suspect there are two reasons for this recovery:

  1. Although the drop in economic activity is deep, it will likely be short.
  2. Supportive monetary policy is a powerful elixir for equities.

Equity markets are forward-looking; investors put their money to work on expectations of future economic conditions and earnings, not based on what is occurring today.  The current downturn is historic.  The decline in the economy has been very fast and deep, but it will likely be short.  In fact, the recovery should begin by midsummer at the latest.  We use these words to mean something specific.

This chart shows a stylized path of the business cycle.  Orange represents expansion, when the economy is making new peaks in an indicator.  This can be GDP, industrial production, coincident indicators, etc.  Blue is recession and is measured from peak to trough.  Green is recovery, which lasts from trough until a new peak occurs.  Finally, once a new peak is made, a new expansion is underway.

We expect this recession to end quickly because the trough will probably occur in Q2.  However, the recovery will be long and likely dictated by the path of the virus.  We currently estimate the new expansion will start in H2 2021.

(Data source: Haver Analytics)

This table shows the declines in the S&P 500 for the postwar recessions.  On average, equities tend to peak about six months before the onset of the economic downturn, while the low occurs about six months after the peak in economic activity.  From the market low to recovery, the S&P 500 usually rebounds by about 20%.  But, notice from deep recessions that the rebound from the low is about 33%.  The rebound we have witnessed thus far is in line with a deep downturn, but it appears unusual due to the compressed nature of the current recession.

Also noted above are the aggressive actions taken by the FOMC.  Below is a chart that will be familiar to regular readers.

From early 2009 until November 2016, the path of the S&P 500 closely matched the Fed’s balance sheet.  There was always concern that the relation was a spurious correlation, and the behavior from December 2016 into August 2019 suggested it was.  However, it is important to note that equities were buoyed by expectations of a massive corporate tax cut.  Taking the balance sheet and incorporating the tax cut gives us a model that offers some insight into the impact of current monetary policy.

Fair value is derived from smoothing the higher marginal rate of the corporate tax and the balance sheet.  Adding the impact of the tax cut accounts for some of the rally in equities.  The sharp rise in the fair value in recent months reflects the massive expansion of the balance sheet.

This is not our forecast for the S&P 500, but it does offer some insight into how powerful the Fed’s actions have been.  We doubt the equity index will track this model due to the level of uncertainty surrounding the path of the economy.  Nevertheless, a projected short, sharp downturn coupled with the most rapid increase in the balance sheet since WWII have created strong support for equities that will likely prevent significant corrections, barring a major policy error or an unexpected negative turn in the toxicity of the virus.

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Daily Comment (May 29, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Good morning and happy Friday!  Global equities are softer this morning as tensions between the U.S. and China continue to rise.  We discuss the latest with China.  As usual, we update what we know about COVID-19.  The Weekly Energy Update is available.  Chair Powell is holding a virtual discussion with former Vice Chair Blinder at 11:00 EDT.  Let’s get to it…

China:  The National People’s Congress has come to a close and it was a momentous meeting.  The decision to extend the national security law into Hong Kong, overriding the former colony’s legislature, strongly signaled that Chairman Xi is done with the “one country, two systems” approach that was adopted at the handover in 1997.  Here are the key points we are watching:

Equity markets have staged a remarkable recovery since the March lows.  As we detail in this week’s Asset Allocation Weekly (see below), much of this rally has been driven by supportive Fed policy.  However, a flare-up in tensions with China is a risk to the rally that we will continue to monitor.

COVID-19:  The number of reported cases is 5,837,541 with 360,919 deaths and 2,437,965 recoveries.  In the U.S., there are 1,721,926 confirmed cases with 101,621 deaths and 399,991 recoveries.  For those who like to keep score at home, the FT has created an interactive chart that allows one to compare cases and fatalities between nations, scaled by population.

The virus news:

  • The good news:
  • The bad news:
    • Herd immunity is the best long-term solution to managing the virus. Unfortunately, the world appears a long way from achieving that level of immunity.

The policy news:

  • The House has passed a bill easing rules on PPP loans. Policy restrictions were discouraging companies from taking the loans so Congress is moving to address that issue.  However, there may be some sticking points about the House bill that will need to be changed to get passage through the Senate.
  • As extraordinary measures approach their end dates, Americans are growing worried that they may not be able to find new jobs or go back to their old ones. If this is the case, the economy could stall later this year.  We do expect other forms of relief to come (rules that reduce the cost of hiring and employment bonuses, for example), but if they fail the economy will bear some risk.
  • The Fed’s balance sheet is now over $7.0 trillion. We noted earlier this week that officials are considering yield curve control.  Policymakers at the Fed are continuing to look for ways to support the economy and, as noted in the opening, Chair Powell may address some of those today.

The finance news:

  • One of the reasons we don’t expect the Fed to engage in negative nominal policy rates is because of the heavy reliance of the non-bank system on money market funding. Negative policy rates would almost certainly cause money market funds to “break the buck” and trigger disintermediation.  We note that money market fund managers are already under stress, waiving fees to offer investors at least some paltry yield.
  • One of the common media questions is, “Why is the stock market ignoring the economy?” As we detail in this week’s AAW, it has to do with the expectations of a short recession and massive policy support.  However, the U.S. equity market isn’t the only one doing well.  The Tehran Stock Exchange has been on a tear.  There are a couple of reasons for this rally.  First, Iranian investors have the TINA[1]  Second, equities do offer some protection from high inflation.  Interestingly enough, we saw something similar in Zimbabwe during its hyperinflation period.  Although rising inflation harms P/Es, stocks do offer some element of inflation protection as firms can boost earnings and become something of a safe haven relative to bonds during periods of high inflation.

The foreign news:

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[1] There Is No Alternative.

Weekly Energy Update (May 29, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

Due to the Memorial Day holiday, the DOE data was delayed until yesterday.  Thus, our report was delayed as well.  Here is an updated crude oil price chart.  The oil market continues to recover after April’s historic collapse.

(Source: Barchart.com)

Crude oil inventories surprised the markets for the third straight week but this time by rising 7.9 mb compared to forecasts of a 2.5 mb draw.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.4 mbpd.  Exports were unchanged, while imports rose 2.0 mbpd.  Refining activity rose 1.9%, above expectations.  As we saw last week, there was another jump in unaccounted-for crude oil.

Unaccounted-for crude oil is a balancing item in the weekly energy balance sheet.  To make the data balance, this line item is a plug figure, but that doesn’t mean it doesn’t matter.  This week’s number of -999 kbpd is the largest negative number on record.  For the third week in a row, this number is running nearly 1.0 mbpd.  It may mean that in the scramble for finding storage, some oil is being inventoried outside the survey system.  In other words, over the week, some 6.9 mb of crude oil went into storage somewhere, just not where it can be recorded.  Or, production is falling much faster than the DOE estimates are capturing so there aren’t any missing barrels; simply put, production is cratering.  We still don’t know which thesis is correct.  Given that imports rose this week, some of the unaccounted-for crude oil may be in storage floating on the ocean and prices have reached a point where some of it is coming ashore.  Nevertheless, it is still quite possible that production is falling faster than estimated.[1]  The second factor is that the SPR rose 2.1 mb as some of the oil went into the strategic reserve.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed a rebound in crude oil stockpiles.  We are getting close to the beginning of the seasonal draw for crude oil.  If inventories don’t decline in the coming weeks, oil prices would be vulnerable to a correction.

Based on our oil inventory/price model, fair value is $28.43; using the euro/price model, fair value is $44.74.  The combined model, a broader analysis of the oil price, generates a fair value of $36.10.  As we have noted recently, the model output is less relevant as there is a non-linearity tied to the loss of storage capacity that cannot be fully captured with these models.  At the same time, if storage remains available, the models would suggest further upside for oil prices.

Although consumption remains depressed, there are reports that driving is starting to recover as lockdown rules ease.  The gasoline supplied data on the chart below also continues to show improvement.  Some data tracking does suggest an upswing in driving activity.

Another way of looking at gasoline is comparing inventories to consumption and calculating how many days of inventory are available at current consumption rates.

The current level is about 10 days above average.  An interesting sidelight is that the drop in gasoline demand has led to a drop in ethanol demand as well.  We get carbon dioxide from processing corn for ethanol which is sold to make fizzy drinks, dry ice, etc.  The price of CO2 is rising.

In market news, the IEA warned that shale investment would likely halve in 2020.  Venezuela received a shipment of gasoline from Iran.  Both nations violated U.S. sanctions; so far, there hasn’t been a notable response from the U.S.

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[1] The weekly production numbers are estimates.  The official data comes with a two-month lag.  The DOE data for April indicates that production was 12.7 mbpd…but even that was an estimate.

Business Cycle Report (May 28, 2020)

by Thomas Wash

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

In April, the diffusion index fell into recession territory for the first time since the financial crisis. Last month, the nationwide shutdown led to the sharpest decline in employment payrolls in the country’s history, while initial claims remain elevated at all-time highs. The financial markets showed some signs of revival as equities rallied the most in history in a month and bond prices rose due to heightened demand for U.S. Treasuries as investors flocked to safety while lockdown orders remained in place globally. Additionally, manufacturing production in certain industries has continued, in spite of the shutdown, to address supply shortages. However, the pandemic continued to weigh heavily on both investor and consumer confidence as there are growing concerns that the impact could continue even after the economy reopens. As a result, seven out of the 11 indicators are in contraction territory. The reading for April fell to +0.030 from +0.393 the previous month, below the recession signal of +0.250.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.

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Daily Comment (May 28, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Good morning!  Global equities are steady to higher this morning after a continued strong march higher.  We update the COVID-19 situation; the U.S. death toll now exceeds 100k.  We discuss the Hong Kong/China situation.  The Beige Book was released yesterday.  We are monitoring hostilities on the China/India border.  The EU creeps closer to a Eurobond.  The weekly energy update report will be out tomorrow as the DOE data was delayed due to Monday’s holiday.  Here are the details:

COVID-19:  The number of reported cases is 5,716,271, with 356,131 deaths and 2,367,292 recoveries.  In the U.S., there are 1,699,933 confirmed cases, with 100,442 deaths and 391,508 recoveries.  For those who like to keep score at home, the FT has an interactive chart that allows one to compare cases and fatalities between nations, scaled by population.  Here is an Axios map showing state infection rates.

Although we are seeing the media roll out headlines as the U.S. crosses the 100k fatality level, it should be noted that the U.S. uses a reporting method similar to Belgium, where doctors can assign the cause of death on either a test or symptoms.  If nations are reporting fatalities on tests alone, it is highly likely they are underreporting virus deaths.  Comparing overall death rates to normal death rates is probably a better way to estimate actual fatalities, but no method is perfect.  The bottom line is that focusing on a particular number isn’t necessarily a true picture for comparison purposes.

The virus news:

  • The good news:
  • The bad news:
    • One issue we have been watching for a while is that COVID-19 may become endemic, meaning it really never goes away. Many infectious diseases have this characteristic, even when a vaccine is available.  We still see outbreaks of measles, mumps, pertussis, etc.  Thus, learning to live with it may simply be part of life going forward.  That doesn’t mean constant lockdowns, but it does mean the precautions for preventing the spread of the virus could become part of life.
    • International hackers are pinging U.S. research facilities to steal medical research on treatments and vaccines. This development shows (a) the potential nations see in being the first to provide treatment, and (b) worries that “vaccine nationalism” may prevent them from getting a new treatment in a timely fashion.  Vaccine nationalism is also on the minds of pharmaceutical companies.
    • Brazil continues to suffer from rising COVID-19 fatalities.

The policy news:

 

  • NY FRB President Williams, in an interview yesterday, said the Fed is “thinking very hard” about yield curve control. This would mean the Fed would set rates for the entire Treasury curve.  If the Fed moves toward funding fiscal activity, such control will likely be necessary.
  • The EU is moving toward a limited Eurobond to fund virus recovery. The EU has proposed a €750 billion fund to support recovery, part of a larger effort, that will be funded by a special EU bond serviced by a series of special taxes.  The “frugal four” remain cautious, but Germany’s support for the measure could cajole them from a veto.  The selling points are that the bonds (a) are special purpose and not for general fiscal activities, and (b) have their own services flows.  But it is a mutual debt instrument and may move the EU toward a true Eurobond, a bond that funds fiscal operations backed by the full faith and credit of the EU.

The finance news:

  • Although LIBOR continues to be used, policymakers are moving to end the life of the benchmark. The alternative, the Secured Overnight Financing Rate (SOFR), will be its replacement.  We will be watching to see when the CME moves the Eurodollar futures to the SOFR futures as the “finishing touches” of the process.  This shift will require millions of loan documents to be repapered to the new rate.  Here is the timeline.
  • Bullion banks took a hit on their hedging when futures prices rose above the cash price of gold. Bullion banks usually hedge their positions by shorting futures, which usually trade at a discount to the cash prices to cover the interest cost.  During the March turmoil, investors piled into futures contracts, driving the futures price above the cash gold price.  In response, banks have backed away from hedging in the futures markets.

The economic news:

  • The Fed’s Beige Book confirmed what we all have seen—economic activity is down significantly. However, there is evidence in some districts that conditions are starting to stabilize.  The districts of Cleveland, New York and Dallas reported that although conditions remain dire, they are not getting worse.  The problems in hospitality were mentioned often.  One other concern that was raised was that generous unemployment insurance, fear of infection and the lack of child care is preventing workers from returning to their jobs.
  • Slow-to-arrive stimulus checks and job losses are putting millions of renters at risk of eviction. Although most state and local governments are not enforcing evictions at present, landlords will likely be forced to move quickly to evict once regulations ease unless the Fed offers landlords and mortgage companies similar relief.

The foreign news:

India/China:  There has been a long history of tensions on the Indian/Chinese border.  However, because the frontier is high in the Himalayas, the ability of the two countries to conduct military operations is severely limited.  Flare-ups are fairly common on the border.  Recently, both sides have been increasing their military readiness around eastern Ladakah.  The region is very remote and, on the ground, borders are somewhat indeterminant.  New Delhi claims that China has moved fighter jets to air bases in the region.  China claims that India has built new roads in the area and worries that the infrastructure would allow India to mobilize troops.  History would suggest that neither side really wants a full-blown military conflict in the region due to the difficulty of conducting military operations in such harsh terrain.  However, both countries have modernized their militaries and may want a skirmish to test their forces.  The U.S. has offered to mediate talks to ease tensions.  We will continue to monitor this situation.

Russia:  Two Russian Su-35s intercepted a USN P-8A reconnaissance aircraft in the Eastern Mediterranean.  The U.S. accused Russia of “unsafe, unprofessional” conduct.

Nord Stream:  The Nord Stream pipeline, which would transfer natural gas from Russia directly to Germany, is back in the news.  The project had been stalled due to U.S. sanctions but the arrival of a special drillship, the Akademik Tscherski, has restarted the project.  The U.S. is considering additional sanctions against Germany and Russia over the project.

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Daily Comment (May 27, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

Risk assets appear set to follow through on their rise yesterday, reflecting not only more signs of a nascent economic recovery from the coronavirus crisis, but also a slew of new stimulus measures in the U.S., Europe and Japan.  We highlight all the key coronavirus and other news below.

COVID-19:  Official data show confirmed cases have risen to 5,615,689 worldwide, with 351,077 deaths and 2,307,901 recoveries.  In the United States, confirmed cases rose to 1,681,418, with 98,929 deaths and 384,902 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

Real Economy

U.S. Policy Responses

Foreign Policy Responses

China-Hong Kong:  In another clear sign that pro-democracy protestors are picking up where they left off during the coronavirus crisis, hundreds of demonstrators gathered to oppose the reading of a contentious law on China’s national anthem in the city’s de facto parliament, sparking renewed clashes with police.  As we’ve noted before, the spiral of tightening controls imposed by Beijing and intensifying protests is a distinct negative for Hong Kong equities.  Importantly, the U.S. is considering a range of sanctions to punish China for its crackdown on Hong Kong, including possibly imposing new restrictions on financial transactions, and freezing the assets of Chinese officials.

Russia-Libya:  The U.S. military has accused Russia of deploying fighter jets to Libya, from a base in Syria, in order to support renegade General Khalifa Haftar in his effort to take control of the country.  Russia has long supported General Haftar, but this dramatic escalation could mark a significant expansion of Russian ambitions in the region.

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Daily Comment (May 26, 2020)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT]

The rally in risk assets around the globe today comes as coronavirus restrictions continue to be lifted around the world, economic activity starts to increase again, and more potential vaccines make their way into trials.  So far today, those bright spots are offsetting the continued risk of second waves of the pandemic and renewed U.S.-China tensions.

COVID-19:  Official data show confirmed cases have risen to 5,519,878 worldwide, with 346,836 deaths and 2,253,651 recoveries.  In the United States, confirmed cases rose to 1,662,678, with 98,223 deaths and 379,157 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

Real Economy

Financial Markets

Foreign Policy Responses

Political Impact

China-Hong Kong:  Pro-democracy demonstrators filled the streets of Hong Kong again over the weekend to protest Beijing’s plan to impose a new national security law on the city, sparking clashes with police.  To reassure investors, President Xi insisted the legislation was benign, and China’s foreign ministry commissioner in the city said it would ensure “a more law-based, reliable and stable business environment for foreign investors.”  However, the proposal is still stoking investor concern that the legislation could undermine the rule of law in Hong Kong and produce a more politicized economic and financial system under Beijing’s thumb.   The crackdown on Hong Kong could also signal that President Xi will eventually take an even tougher stand on reunifying Taiwan with China, even as he pushes to gain Chinese control over the East China and South China Seas.  All of these aggressive initiatives, along with efforts to coopt countries ranging from the Philippines to Italy, carry the risk of U.S. sanctions, financial market decoupling, or, eventually, military clashes.  They also exacerbate other U.S.-China tensions ranging from trade relations to disputes over whether China is to blame for the coronavirus pandemic.  Hong Kong stocks have already been hurt by the proposed security law, but the worsening relationship between the U.S. and China also presents a risk to global stocks in the longer term.

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Asset Allocation Weekly (May 22, 2020)

by Asset Allocation Committee

Beginning in the late 1990s and becoming an even bigger issue after Dodd-Frank regulations were imposed following the Great Recession, many market participants worried that bond market liquidity would be absent in the face of a crisis.  Strict regulations discouraged banks and brokerage firms from holding large inventories of corporate bonds, thereby precluding them from their former role as willing buyers in the face of a wave of selling by investors.  Compounding the concerns were the sheer size of flows into traditional open-end and ETF bond portfolios.  Over the 10-year period from 2009 through 2019, a total of $2.7 trillion flowed into these instruments, almost a third of which were in ETFs.  Entering the fray was the popularity of risk parity funds that levered their bond holdings.  Though each risk parity scheme has a nuanced approach, they all act in a similar fashion.  The concerns were that when risk parity funds and individual investors rushed to exit their bond holdings, market liquidity would be absent, particularly for corporate bonds.  Numerous studies and articles appeared over this time frame warning of dire consequences for bond investors, notably violent price movements due to the fact that banks and brokerage firms were no longer participating to a significant degree to assist in maintaining order to the bond market.

In March, the veracity of these concerns was tested as the bond market worked its way through the financial stress triggered by the pandemic.  During this episode, ETFs proved their endurance by moving into the void and providing the necessary stabilization of the market.  The use of creation/redemption units on the part of Authorized Purchasers [APs] mitigated the severity of the downturn, especially among investment-grade corporate bonds.  As the accompanying chart illustrates, spreads for BBB/Baa-rated corporates relative to the 10-Year Treasury gapped to their widest level since the Great Financial Crisis, yet quickly repaired.

An examination by Blackrock of the trading during this critical period in its largest corporate bond ETF, the iShares iBoxx Investment Grade Bond ETF [LQD], provides evidence that not only did the activities of the APs aid in maintaining market liquidity, but the market price of LQD actually led the price discovery process.  In other words, rather than the market price exacerbating the premium/discount to net asset value [NAV], the market price was the precursor of the daily NAV print.  Moreover, the direction of the market price of LQD often preceded the direction of LQD’s indicative value [IV], which is the real-time estimate of its fair value, based on the most recent prices of its underlying bonds.  Since LQD’s 2,169 underlying bonds trade over the counter, and therefore many may contain stale pricing, the price discovery proved invaluable to market functioning.  After the dust settled, it was evident that LQD and other bond ETFs provided market pricing that was at least as good as, and oftentimes better than, individual bonds.

 

As of 4/8/2020.  (Sources: BlackRock, Bloomberg and Refinitiv)

Although the market function provided by LQD during the period is not necessarily indicative of every bond ETF in each bond sector, it does underscore the notion that ETFs can provide the necessary liquidity during a period of crisis.  The creation/redemption mechanism of ETFs allow for arbitrage opportunities and allow the supply/demand of the ETFs to achieve equilibrium with the value of the underlying bonds.  In essence, ETFs are now creating most (if not more) of the liquidity previously provided by banks and brokerage firms, often doing so with greater efficiency.

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