As with our “Markets” section in our Full Report today, we’ll take the quiet day to catch up on a few topics:
#1: The Federal Reserve was out last week with its COVID bank stress test scenarios; the ones banks will have to pass later this year. This is on top of the usual annual stress tests, the results of which were out earlier in 2020.
We’ll confess to having a morbid curiosity regarding how the Fed thinks about “worst case scenarios”, but in fairness we’re not just doom scrolling.
- The Fed’s scenarios can give useful information about when they may step into a market to support it during market volatility. That’s what happened in April, when corporate bond spreads looked like they were going to hit the Fed’s 2020 “severely adverse scenario” of 6.5% (they got to 5.6% in a hurry).
- More generally, we’re curious as to how the Fed models GDP, inflation, and unemployment relative to capital market levels and volatility. All these tend to go non-linear in a crisis, so the Fed’s models are at least a starting point for considering worst case scenarios.
For the latest stress test, the Fed actually has 2 scenarios: severely adverse (one sharp shock in 1H 2021) and an “alternative severe” possibility (a long slow grind throughout 2021). A few highlights from each:
- US Unemployment: either a peak of 12.5% in Q4 2021 (severe scenario) or a long grind of 11.0% joblessness all through 2021 (alternate).
Note: the 2020 peak was 14.7% in April 2020.
- Inflation: CPI either takes a header to 1.2% early in 2021 but then bounces back (severe) or lingers around 1.7% for most of 2021 (alternate).
Note: the trough in May 2020 was 0.2% and CPI inflation is currently 1.3%.
- 10-year Treasury yields: both the severe and alternate scenarios have 0.3% as the trough in long-dated Treasury yields.
Note: the March crisis lows for 10-year yields was 0.50%.
- BBB corporate bonds yields: either a peak at 6.1% in Q2 2021 (severe) or 6.4% in Q4 2021 (alternate).
Note: BBB yields are currently 2.35% and, as mentioned, peaked in March at 5.6%.
- US Stock prices: either a trough in Q2 2021 at levels 47% below today’s close (severe) or 46% down from today in Q4 2021 (alternate).
Note: both scenarios have US stocks trading 20% below the March 2020 lows.
Bottom line: we have no idea how the Fed models positive CPI inflation and 10-year Treasury yields in its severe/alternate scenarios, but the capital market worst case scenarios are worth considering. Basically, the Fed doesn’t think Treasury yields will go to zero or negative even if stocks decline by +40%. We’ll take the other side of that trade, but what the Fed is implicitly saying is that even long dated Treasuries will not do much to hedge equity exposure in a worst-case scenario.
#2: AQR’s Cliff Asness has taken a well-deserved break from defending value investing and recently turned his analytical eye to the long-held belief that small cap US stocks outperform large cap equities. The title of his blog post on the topic is blunt: “There Is No Size Effect: Daily Edition”. There is a link to his analysis below, but here are his key findings:
- “Small cap stocks beat large cap stocks historically but that’s only before adjusting for market beta …”
- “Any way you slice the above there is nothing even resembling a long-term simple small firm stock effect …”
- “Adding in lags to account for illiquidity takes the historically weak small firm effect and renders it non-existent…”
Bottom line: what’s novel about Asness’ work here is how he considers small cap liquidity (that final point) by looking at daily returns and implied betas. As he points out towards the end of his post, “Adjusting for that leads to a dramatic turnaround in beta (and dramatic reduction in realized alpha) that perhaps even better illustrates the (liquidity) phenomenon…”
Our take: the only reason to own small cap indices like the Russell 2000 is because you want outsized exposure to cyclical industries and easing financial conditions (i.e. lower higher yield spreads), which commonly occur at the start of an economic cycle.
#3: We want to very briefly touch on European Financial stocks, a perennial source of bearish storylines. Consider the price action in the MSCI Europe Financials Index (ETF symbol EUFN, chart courtesy of MarketWatch) over the last 10 years:
Bottom line: your eyes do not deceive you – this group is down 45% from its 2014 and 2018 peaks, off 31% year-to-date, and is basically trading right where it was during the Greek debt crisis. Perhaps the sector will one day consolidate around a few key players and generate some decent returns. Or not… But this is not one of those charts that signals “crisis”; those tend to have a large gap down and then a slow grind to zero. Rather, it’s just the chart of a badly managed sector in a no-growth environment.
Fed Stress Test Scenarios: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200917a1.pdf
Cliff Asness “There is No Size Effect”: https://www.aqr.com/Insights/Perspectives/There-is-No-Size-Effect-Daily-Edition