Ashwin Alankar, Head of Global Asset Allocation, says the market sell-off has increased illiquidity in financial markets and that a targeted policy response is needed to stave off the potential for small business defaults, which would greatly weigh on economic growth. However, options markets now signal more reward than risk in equities.

   Key takeaways:

• In the current market environment, higher-risk asset classes such as high yield bonds have seen liquidity start to dry up, impacting even normally liquid instruments, such as ETFs.
• Markets are also panicked about potential bankruptcies, particularly among small businesses that rely on a constant flow of customers for revenue – now at risk because of social distancing measures. A significant policy response will be required to support these businesses and forestall a financial crisis.
• With the US 10-year yield now well below 1%, Treasuries may not provide enough of a cushion for equity losses. However, options prices suggest that the risk premium for equities looks attractive. We also believe short-duration bonds could help provide diversification.

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Ashwin Alankar: So, given the onset of the coronavirus and how the market has been responding to the coronavirus, liquidity has certainly been compromised. You were seeing it, for example, in places which are somewhat unexpected, like the ETF [exchange-traded funds] market. One of the issues with the ETF market is people expect ETFs to provide daily liquidity. People expect to be able to transact them at the index price, but if you get into a situation where you’re holding particular ETFs like the high yield ETFs, which is packaging high-yield bonds, and those underlying instruments are inherently less liquid than the ETF, in periods like this that lack of liquidity in the underlying will showcase itself in the liquidity of the ETF. And you’re seeing that today. You’re seeing the liquidity that people thought they were going to get holding ETFs starting to dry up.

The high yield bonds, even the investment grade bonds, are one of the clearer examples of where this is happening. But the S&P 500^® ETF, the underlyings are very liquid, so the S&P 500 ETF is not going to show any liquidity issues. But where the liquid instruments begin to show issues is when you’re trying to liquidate positions and aren’t able to liquidate positions in illiquid holdings. So, for example, you have a position in a distressed bond fund. What you automatically do is try to gain liquidity; you try to raise cash by selling your most liquid holdings. So that lack of liquidity in the distressed bond fund starts to translate into liquidity premiums building in in liquid instruments.

So, prior to this crisis the economy looked great. That has all changed recently, and the stress that the market is worried about today has gotten to the point where they’re worried about bankruptcy risk. They’re worried that this demand shock, which has come about in such a rapid and sharp fashion, will put pressure not on the Microsofts of the world but on small businesses. Small businesses are suffering today because no one is comfortable leaving their homes going to a restaurant; no one is comfortable leaving their homes going to see a movie. So, these small businesses, which rely on a constant flow of customers, on a constant flow of revenues, are now suffering a revenue shock. Then you have the double whammy of the oil price shock. So not only are small businesses now faced with bankruptcy risk, shale companies, as an example in the US, are faced with bankruptcy risk because they are not designed to operate profitably at $20 or $30 oil.

So, to solve this problem, you have to target the source of the risk, which is this bankruptcy risk. So, the US government needs to support small business, needs to support these shale companies by giving them cheap and/or free financing. Why that’s important: If they have the financing to pay for their leases, if they have the financing to pay for employees on their payroll, that then does two things. One, people don’t get laid off, so unemployment numbers don’t spike, which then lead the consumer to default on consumer loans, and the small business and the shale company doesn’t default, so banks are much stronger. Otherwise, if you get this contagion of defaults, some of these bigger banks and even the smaller regional banks, they start suffering capital hits. Then you get your classic standard financial crisis.

There is a silver lining of what transpired over the past two weeks, is you’ve had terrific diversification between bonds and equities, between Treasuries and equities. Treasuries have rallied a tremendous amount; historic rallies in Treasuries to help offset those historic losses on equities. But going forward, with US 10-year yields, for example, well below 1%, will Treasuries offer the cushion and the hedging power that they have over the past three weeks to help offset losses on equities? Maybe not. That ability to diversify, that ability to hedge, that ability to cushion against equity losses may be compromised, which then poses a very important question: What do you do in your portfolios to hedge equity risk if bonds aren’t going to do that? You have to think very creatively about that. You have to think about [the benefits and risks of] holding short-duration bonds at this time. That might be your only source of diversification with yields so low unless the government and central banks are willing to push rates far, far, far into negative territory.

So, one of the most interesting things that we are seeing in the option-market pricing of risk going forward: The option-market signals are quite contrarian. Option markets are telling us that the risk/reward to equities, such as the S&P 500, are actually pointing to more reward than risk. So, as many people have talked about, that this could be a short-term drop in the markets followed by a very swift recovery, particularly if fiscal stimulus comes into play, that recovery could be very, very, very fast, which we find to be quite interesting given being inundated with negative news. The option market seems to be filtering through this negative news and this potential noise, and saying, hey, the risk/reward, the risk premium on equities is actually looking quite attractive.