The Great Rebound | 1-Year Anniversary of Black Monday II

Reading time: 7 minutes

The beginning of March 2021 marks the first anniversary of the elevation of COVID-19 to the status of a pandemic. It has also been a year since the growing concerns about the economic consequences of the pandemic, coupled with the oil war, caused the collapse of worldwide stock exchanges. 

The stock market crash of 2020 began on March 9, when the Dow Jones Industrial Average (DJIA) registered its worst single-day point drop in history of 7.79%. This fall was followed by two further record-high plunges, first on March 12 (-9.99%) and then on March 16 (-12.93%). This alarming tumble ended the 11-year bull-market started in March of 2009, with the lowest point – a 33% fall from February-of-2020 highs – being reached on March 23. The DJIA has been recovering ever since, accumulating a 68% gain by March 17, 2021

Source: CNBC, Figure 1 – 10 biggest one-day point losses in DJIA history

Did the FED finally get the formula right?

Milton Friedman, the renowned Nobel-prize winning economist, published in 1963 what would be then remembered as a ground-breaking book regarding monetary policy: A Monetary History of the United States. In one of its most famous chapters, where the author focused solely on the Federal Reserve’s actions during the Great Depression, he pointed out several reasons to why the FED had not only perpetuated the crisis for more than a decade (after the famous 1929 crash), but also had helped worsen it. Three of the main reasons sustaining his arguments were the lack of liquidity it provided to the economy, enabling disastrous bank runs, the lack of forward guidance, a tool which informs investors about future interest rates policies, and the time they took to put their policies into practice. Consequently, the US faced deflationary and unemployment levels that, to this day, are still regarded as having acted as catalysts for the worst American crisis in history.

Source: Federal Reserve History, Figure 2 – Ben Bernanke speaks about the Great Depression

Ironic enough, it was under Bernanke’s term as Charmain that the second most devastating financial crisis (only less severe than the one initiated in 1929), in late 2007, took place. However, once again, and despite the reduction in the Federal Funds Rate from 5.25% to 0-0.25%, combined with similar forward guidance, the enormous QE, Open-Market-Operations Programs and even the controversial bailouts from the “Too Big to Fail” who had gotten into the subprime mess, the consequences drawn from the time taken to implement these policies are still regarded as a big mistake.

But how does this relate with the current economic downturn and the stock market?

Unlike the previous two major recessions, often described as man-made crises, the stock market collapses that followed were pretty much impossible to contain by any federal institution, as they were caused by investors realizing they held worthless assets from financial companies destined to bankruptcy. These collapses ended up damaging the ability of the economy to bounce back faster, as businesses saw their savings being erased from day to night, then lost the ability to fund their activities through capital raisings and, ultimately, closed doors.

However, this time, society was faced with a nature-made crisis. There was no systemic cancer under the economy. Despite generous stock valuations, the crash starting in March was mostly due to an exogenous shock leading to expectations of yearly negative economic growth. Therefore, the Fed made sure to leverage on that detail as much as possible, by trying to have the stock market at its side and prevent even worse economic outcomes.

By March 15, even before lockdowns started in the country, the Fed had already adopted the same expansionist monetary policies as in 2008 and, on March 23, made QE open-ended, a euphemism for “unlimited funding until needed”, ending there the stock market crash and its bearish trend. It has also been supporting loans to businesses with near-to-0% interest rates, giving rise to the so-called “zombie companies”. These are businesses that were in fragile conditions before the pandemic, but which were able to keep its activities, due to the bailouts. The percentage of these firms in the Russell 3000 as lately reached values close to the dot-com bubble.

Source: Financial Times, Figure 3 – The rise of ‘zombie’ companies

These measures, alongside supporting fiscal policies coming from the government, have been creating a liquidity phenomenon characterized by a shift from fixed income to equities, due to the unattractive yields being carried by investment-grade securities. It has been growing the investors’ appetite for growth and speculative stocks, with valuations as a whole being totally disconnected from the economic reality.

The rise of retail investors and sector performance during the pandemic

Source: Fortune, Figure 4 – The rise of retail traders

There has been considerable surge of day trading since the onset of the pandemic. With many people stuck at home and extra income brought by the Relief Package Deals, there has naturally been an increased curiosity in trying to make money from the stock market.

In the first quarter of 2020, day trading increased dramatically when compared to 2019. TD Ameritrade, one of the online brokers that provides access to such activities, reported that visits to its website giving instructions on trading stocks have nearly quadrupled since January 2020. JPMorgan estimates that the brokerage industry added more than 10 million new accounts during 2020, mainly on commissions-free brokerages.

Some of these new retail investors are induced by the gains other people have made on certain stocks. They follow short-term speculative plays, attracted by the promise of big gains, which do not turn to be the case most  times. The main focus of these new investors were mega-cap growth stocks, especially tech-related. These were among the big winners, alongside industries such as online retailers, cryptocurrencies, housing and solar. On the losers’ side, one can find travel and leisure, oil and gas, banks, and manufacturing.

Stock Market vs Economy: related, but not related

While the past year has seen a great economic downturn, the evolution of the stock market since the crash seems to contradict this pattern, as aforementioned.

With the current economic situation failing to keep up with valuations, there are reasons to believe the stock market is highly overvalued, leaving investors in the fear they may be facing a dangerous speculative bubble that might burst at any moment. History has shown that tables may turn at any moment and this likelihood is increasing with volatility in investors’ confidence and uncertainty regarding the effectiveness of the vaccines.

Source: Bloomberg, Figure 5 – Buffett Indicator

Overall, it is true that most of the times the stock market and the economy do not fluctuate in tandem and there is evidence that they have been negatively correlated (-0.04 correlation over the past 10 years). 

Source: US Bureau of Economic Analysis, Figure 6 – Stock Market Performance vs Economy

All things considered, stock market fluctuations may be due to various reasons external to economic performance, the most prominent one being the unpredictable behavior of investors, whose confidence and moods change drastically from one moment to another, many times for no apparent reason or tied to either unrealistic optimism or subconscious fear of the future performance of the market. 

What does the future hold?

The inability for investors to predict an upcoming crash was still very much present during last year’s rally, with many unable to comprehend how such a big economic downturn could coexist with such a strong bull market. Nonetheless, these past weeks may have brought to light some of the stock market’s weaknesses, by showcasing how fragile it is to inflationary expectations. It seems that the lack of action coming from the Fed to contain inflation at targeted levels and real yields at positive ground have triggered a sell-off from US treasuries and an upward movement in long-term yields. However, with risk-free rates increasing and becoming more attractive, highly-speculative and growth stocks have also been suffering from the new discount factors in play, and from massive corrections leading up to a rotation to bonds and value plays.

It is still unknown whether these events can trigger a potential crash or only minor corrections, but, once these become coupled with possible bad earnings seasons or any slips coming from the vaccines rollouts, you might want to hold on to your cash, stand back, and enjoy the show.


Sources: Bloomberg, CNBC, CNN, Corporate Finance Institute, Federal Reserve History, National Bureau of Economic Research, The Balance, Visual Capitalist.


Francisco Nunes

Diogo Almeida

Inês Lindoso

US Elections 2020 and the Stock Market

General effect of elections on the Stock Market

Political stability is known to be one of the most relevant requirements for one to invest in a given market. Given this fact, it is no wonder that the United States have been the number one place to invest in over a century. One may say its capitalist policies have been the primary cause to that result but it is also important to notice that, unlike many of its European and Asian peers, this country has been under an ongoing democracy since 1776, which ultimately led the country to be seen as one of the most safest and transparent places to do business in.

Since we are talking about one of the main drivers of the current world economy, any political deviation tends to trigger either positive or negative worldwide economic forecasts, thus, influencing financial markets as whole.

Going into the most recent elections between Joe Biden and Donald Trump, and despite the polls pointing from day one to the Democratic nominee, expectations about bullish or bearish views on the market (e.g. Energy Sector) were highly reliant on this election. However, it is important to bear in mind one very important aspect: both the Democratic or Republican parties believe that, under their own policies, the overall economy will grow at a faster and sustainable pace than under the other. Therefore, usually there are no major setbacks in stock markets since a large share of the US population must trust on the chosen economic strategy.

 


But for how long can this volatility affect the market?

Let’s use for example the two most disputed elections of the new millennial:

Al Gore vs George W. Bush 2000 election

In the midst of a Dotcom Bubble and a slowing US economy, the Al Gore vs George W. Bush clash took place, leading to one of the most disputed elections the country had ever seen, with a losing candidate having more popular votes for the first time since 1888 (Gore had approximately more 500.000 votes than Bush). After a very close race between both candidates, Florida’s 25 electoral votes were called “too close to call” after George W. Bush had won the state by a mere 900 votes out of a 6 million ballots cast. Such a close margin led Gore to demand a recount by hand in vary crucial counties, thus, postponing any official announcement for 36 days, and taking Wall Street into some red territory.

Overall, the S&P 500 had tumbled 7.8% during the recounting of votes and the final decision by Florida’s Supreme Court to overrule that same recounting.

Picture 1.png

Hillary Clinton vs Donald Trump 2016

During the final hours of the shocking 2016 elections, investors once again feared that no one would come out victorious as Florida’s counting was already looking similar to the one seen 16 years before. As so, Dow Futures plunged as much as 5% in the after-market, as a close call could once again lead to a lingering recount. Nevertheless, Hillary Clinton conceded the victory shortly after the official results came out, bringing relative calm to the stock market and even giving it some momentum.


Picture 2.png

What were the markets betting on?

For months, the world had its eyes on the U.S. Elections and last week’s slow and excruciating wait for its outcome left millions of people worldwide constantly refreshing electoral maps and predicting its result. As millions of individuals around the globe, the stock market also established its prediction, based on one specific indicator: the S&P 500’s performance.

Historically, since World War II, 88% of the times the most relevant equity index in America fell in the three months prior to the election, the incumbent party lost. On the other hand, when the S&P 500 showcased some growth, the incumbent candidate for the presidency has won. This year was no exception. Until little time prior to the elections, the index was predicting a Republican win, yet, on the last Friday of October, markets were shaken and the S&P 500 drop 1.2%, registering a 0,04% plunge between the last days of July and October that, despite the very slight margin, meant a favorable result for Joe Biden, the Democratic candidate.

Despite the general idea that a Trump presidency would ultimately benefit Wall Street due to lower taxes and loose regulations, investors, businesses and the overall corporate America showed no worries of a possible blue wave, even considering Biden’s explicit support of a higher corporate tax rate, stronger unions and an expansion of government-run health insurance.Indeed, according to Harvard Business School professor Deepak Malhotra, “There is a growing sense that for business to do well, [and] for the economy to do well and to grow, you need a government that’s functional” matching JPMorgan statement that, despite the “consensus view” that a “Democrat victory in November will be negative for equities”, the multinational investment bank sees this “outcome as neutral to slightly positive”. Furthermore, Goldman Sachs stated that a Democratic win would increase the possibility of a fiscal stimulus package amounting to $2 trillion by the time of Joe Biden’s inauguration and his plans to increase spending on infrastructure, health care and education would ultimately “match the likely longer-term tax increases on corporations and upper-income earnings”. Supporting such predictions, Moody’s Analytics investigation outcome showed that Biden’s economic policies would create more 7.4 million jobs that Trump’s would, leading the economy to return to full employment by the second semester of 2022.

One should also not forget the fact that Joe Biden, given the current predictions, will rule the US under a Democratic Congress and a Republican Senate accentuating the need for compromise in all future policies. Rumors have it that Mitch McConnel and Biden have a healthy and professional relationship of mutual respect and they have worked well in the past, but only time will tell if the Senate will constitute an obstacle to the future POTUS or a means of achieving bipartisan consensus regarding the future of the United States of America.


The Evolution of the S&P 500 in the post-election: Markets seem to like Joe Biden so far

The Evolution of the S&P 500 in the post-election: Markets seem to like Joe Biden so far


Ultimately, investors dream about stability and smooth transitions of power. The latest remarks made by President Donald Trump before and after the elections, where he refused to concede to Biden and promised to legally contest the voting outcome, worried financial markets. Uncertainty surrounding the most powerful office in the US means trouble for investors and, due to this fact, we dare to say that they are looking forward to a Biden presidency and a peaceful ending to the Trump era. At the moment this article is being written, the outcome of the election does not seem final since top Republican officials are backing Trump’s unfounded accusations of election fraud pushing the process to the courts of law. If there is not a clear victor soon or if Donald Trump continues to refuse the will of the American people, markets will get edgy and volatility will be the law, in the short run.

Day Trading

What is Day Trading?

Day trading is the practice of buying and selling a security on the same day. That is, an investor enters and exits the transaction on the same trading day, and no open positions are maintained overnight. It essentially occurs in any market; however, it is more prevalent in the stock and foreign exchange markets. It entails using large amounts of leverage to make the most of price fluctuations, be it a short or long trade. Given gains are made on swift price changes, investors seek out volatile and highly liquid assets.

 Day traders base their decisions on numerous indicators, news, scheduled announcements (e.g. corporate earnings, interest rate changes) while trying to predict future market inefficiencies that can be exploited for capital gain. Meanwhile, day traders try to rely as little as possible on their gut feeling and emotions, for that reason money invested is often the amount they can afford to lose.

 The most common trading strategies range from making numerous small profits on various small price changes (Scalping), to take advantage of the volatility created by news events (News-Based Trading), all the way to using algorithms to identify and make the most of small market inefficiencies (High-Frequency Trading).

 Day trading can be traced back to 1867, before computers, the internet or even electricity existed. Stock markets used the telegraph’s communication technology to create the ticker tape, the earliest electrical dedicated financial communications medium, which allowed for brokers’ transactions to be communicated. In the past, those who were able to day trade were brokers working for large institutions, which managed the firm’s money, as well as that of its clients. They had access to a direct trading line, a trading desk, great amounts of capital and highly advanced analytical software. Nevertheless, the position of day trading has extended to anyone interested, though with a more limited know-how and access to financial tools, as platforms now offer lower fees.


Different types of strategies 

Each trader usually creates his strategy based on one simple criteria: Risk. As financial markets teach us every day, trading on riskier approaches tend to end up either in disastrous trades or in absolute jackpots or, on the off chance the market shows low levels of volatility, the gains/losses can be closer to zero. However, professional and retail traders tend to focus more on volatile and high beta’s assets that, at the end of the day, can turn a soft overall market movement into a considerable profit return for the portfolio. Traders do have to consider the need to top commission fees so that the high number of trades won’t eat up the gains and leave them holding nothing.

Taking these facts into account, traders choose the strategy of which they feel mostly suits their reach. So, components as the time, money willing to involve on the portfolios, experience in trading, and the knowledge behind market movements may drive different approaches from traders.

Arbitrage Trading:

Arbitrage is solely the act of purchasing and selling a financial instrument by exploiting market inefficiencies.

Take for example the simplest arbitrage trade possible, imagine you hold Apple stocks and you realize that it is selling for $118 on the NYSE and it has a bidding price of $117.5 on the LSE.  With this you could incur in free-of-risk transactions from one Stock Exchange to another until the market gets corrected, which until then, profit would be assured. However, arbitrage opportunities are said to have gone extinct for retail investors due to the highly computerized financial software, which when any dysregulations like this occur, are promptly put to an end by the fastest market-maker that sees it and takes advantage of it with the use of advanced algorithms.

Swing Trading:

Swing trading is a type of trading that implies seeking for a big chunk of a potential price movement, instead of settling for small movements caused from natural volatility. Due to the end goal that this strategy aims to achieve, it usually forces the trader to hold the security overnight and to sell it in the following days. This method highly relies more on technical analysis rather than on fundamental analysis, considering the trader incurs in the purchase and selling of the security regardless of what he believes the intrinsic value of the asset is. A swing trader supports his decisions by looking for common patterns, moving average crossovers, cup-and-handle, as many other multi-day chart patterns in order to set the buying price and then the chosen Stop Loss/Take Profit values.

Picture 1.png

News Trading

As the name suggests, news trading strategies implies the trader to make its judgement of pursuing a transaction based on news and rumors, either before they are announced or after. This type of strategy does not require the trader to undergo any detailed technical analysis but rather to focus its trade on the qualitative side of the fundamentals of the company, thus, in this case, to know if the announcement or the new will meet the markets expectations or, if on the other hand, might change the investors’ opinion of the companies’ value.

Merger Arbitrage

Often referred to as Hedge Fund strategy, this strategy comes from the purchasing and selling of a stock that is supposed to be acquired by a second company at a higher price. This type of strategy involves calculating the probability that either the merger is going to be settled at that given price, as it will occur at the time expected.

One controversial example in the Portuguese stock market’s sphere was the “Benfica’s takeover bid” (OPA do Benfica). Benfica filed in for a takeover bid on its “SAD” in November 2019, by willingly acquire about 30% of its shares for a price of €5, when its stock was at the time valued at €2.71. Traders soon pumped up the stock to a value close to the acquisition one, only to see that acquisition takeover overruled by the Portuguese Securities and Exchange Commission a few months after.

Picture 2.png

Why is it so controversial?

Day trading is regarded as one of the riskiest ways to invest your money in financial markets nowadays. There is still a general idea that this type of trading is just gambling and a scheme to make bulky profits within days. Furthermore, most experienced asset managers and financial advisors have a negative opinion regarding day trading stating that the risks almost never justify the gains received. When we long at the long-turn, day trading practices tend to underperform traditional investment practices. It is true that it often includes leveraged positions that can make traders lose much more than they initially invested, and this often happens. Although traders are only forced to show their gains and losses to IRS, several studies and market research data show that their success rate is very low, only a small percentage managing to consistently deliver relevant gains, considering the high amount of brokerage fees they pay.

Advantages of Day Trading

 Although day trading practices are shown to be risky, from what we saw earlier, they are quite common today and there are reasons for it. The most advertised by day traders is the huge gains that they can make in relatively shorter periods of time. Despite depending on the amount of money that a trader is willing to risk at each trading session, the leverage mechanisms available can transform small investment sums into robust sums of money. This makes a lot of day traders believe they will be part of the small portion that is able to beat the market.


Final Thoughts

Day Trading is definitively risky by itself, it requires a filled margin account to start with and any potential profit is already cut by the brokerage fees of making many trades every day (this burden will depend on the brokerage firm). Data shows that most day traders lose money and a high percentage of the ones that have any gains have a small profit margin. With all this information in mind and considering the inherent risk, it is a legitimate way to make a significant return with low-enough initial capital and in a few days or weeks. Day trading is not for the faint of heart and is only advisable with the right market information and experience in financial markets. It ultimately falls on each investor to decide if the reward is worth the risk.

Picture 3.png

Sources: Investopedia, BeBusinessed, MelMagazine, The Balance

The exuberant IPO (Snowflake Part II)

Snowflake started trading on the 16th September 2020 on the New York Stock Exchange (NYSE) and it could not have a been a more successful Initial Public Offering (IPO). Under the ticker SNOW, the company took the central stage in the largest IPO of an American software firm.

Goldman Sachs was the investment bank responsible for Snowflake’s IPO and it left some people wondering if the respectable Wall Street institution had not made a huge mistake and mispriced this IPO. And the reason was the first day of trading: Snowflake’s shares were priced at $120 and they increased more than 160% reaching $315, before closing at $253.93, which is still almost 112% higher than the IPO price.

Although this is not unheard of, since we have the case of LinkedIn and dozens of examples during the dotcom boom, only a very small percentage of IPOs tend to double in value in their first day. But there is a better explanation than the fact that Goldman Sachs and Snowflake failed to correctly assess the company’s market value. There were several institutional investors that traded the company’s shares for a quick profit and others that just held their position, but the real main drivers of this one-day bubble were retail investors that traded over and over the same number of shares similarly to what has happened in the recent “tech bubble”.

The bottom line is that Snowflake was able to raise $3.4 billion and, by the end of its first day of trading, it displayed a $70.4 billion valuation, which is more than five times its private valuation in February of the same year.


A “sell” rating from Summit Insights Group marked the first analyst rating of Snowflake, earning the title of “the most expensive name in all tech”, despite its impressive debut in the public market. Srimi Nandury, analyst at Summit Insights Group, expressed concerns about Snowflake’s valuation stating that combined with its “limited differentiation” from company’s such as Google’s BigQuery, and Amazon’s Redshift, “For the stock to work from the current levels, Snowflake needs to execute flawlessly quarter after quarter, and have to live up to lofty expectations and grow into its valuation”. Indeed, Snowflake shares are considered to be at risk of a sharp reversal, stepping into bubble territory. Moreover, the tremendous run presented by the stock placed SNOW as an unstable stock, yet investor’s enthusiasm is undeniable and, as previously mentioned, retail investors were primarily responsible for the gains, rather than institutional players.


 If the hype for the cloud-based data provider was already high, news that an unprecedented move coming from Berkshire Hathaway, the half a trillion-dollar company that put Warren Buffet on the map, caught every investor by surprise, sending demand even higher.

The 90-year-old investor is known for its aversion to tech companies, which he has stated of failing to see their potential where there is one. Moreover, the fact that this is a high-growth, money-losing and expensive-looking stock, news stating that Berkshire was investing as much as $250 million in the IPO, plus a 4.04 million shares (at debut price $120) bought from Berkshire directly to a stakeholder (a total investment of $730 million) caught everybody off guard. And if this was seemingly confusing to investors who have followed the investing rationale chosen over the years by Berkshire, the fact that Buffet has been a criticist over the years of investing in new issuers, comparing it mostly to gambling, created the speculation that the decision behind this investment was being made by Buffet’s lieutenants: Todd Combs (also CEO of GEICO) and Ted Weschler, who manage about $14 billion each worth of Berkshire Hathaway’s portfolio.

In fact, in an interview given to CNBC in May 2019, after asked on whether he would be interested in buying Uber’s IPO, Buffet responded saying “ In 54 years, I don’t think Berkshire has ever bought a new issue (…) The idea of saying the best place in the world I could put my money is something where all the selling incentives are there, commissions are higher, the animal spirits are rising, that that’s going to better than 1,000 other things I could buy where there is no similar selling enthusiasm and the desire to get the deal done… we like to buy things where nobody is making a dime”

Right philosophy or not, Berkshire had a return of around 110% just in the first trading day, profiting an absurd amount of around $800M on one stock which, at the end of the day, is a huge outsider under the holding company’s portfolio.


A study conducted by Harvard Business School professor Malcom Baker and New York University finance professor Jeffrey Wurgler uses the first-day return of IPOs as an indicator to quantify investors exuberance and explains “ because it is impossible to short-sell IPOs, the first-day returns are driven by sheer speculation and optimistic buyers who may or may not do their homework on any given deal”. If we calculate the average of the first-day returns of IPOs so far this year we get a value close to 42% – the highest percentage since the internet bubble in the late 1990s. Particularly in the sector to which Snowflake belongs, this year already 12 technology IPOs in the US have priced above their initial range and increased their value since they went public – as an example, take a look at Shrodinger Inc. (229.7%), BigCommerce Holdings Inc. (212.3%) and nCino Inc. (143.7%).

Therefore, it is important to understand the factors in the origin of all this enthusiasm around cloud-software companies. One of the explanations was given by Jacob Shulman, the chief financial officer of JFrog, another company from the software sector which debuted this year on Nasdaq. For Shulman, which defended that the COVID-19 pandemic strengthened the existing relationships between costumers and companies that can help employees maintain productivity while working for home. For Shulman, software is becoming an integral part of our lives and the pandemic just crystalized the need for digital transformation. Indeed, if we take a look at the development of Zoom which increased 1100% since its IPO in 2019, Shulman could be right. Also, some specialists argue that recent enterprise technology companies take into consideration the fact that being a public company enhances their credibility when selling to new costumers – one more possible explanation to the recent increase in the number of IPOs in the tech sector.


However, back to the study of Baker and Wurgler, evidence was found that the stock market historically has produced below-average returns when investors are exuberant. Thus, should we fear a bubble burst like the one back in 2000? For Jay Ritter, a scholar from the department of finance at the University of Florida, defends that new conditions exist nowadays, making a crash less likely. For instance, the decline in the stock market during February and March could have created such fear and uncertainty that IPO underwriters have been reluctant on setting too high an initial offering price. Therefore, as a consequence of setting low prices, IPOs enjoy bigger first-day bumps after going public. Furthermore, nowadays firms have also some differences when compared with tech companies from the 1990s. The new tech companies now go public relatively later and have already demonstrated that their products or services have demand and many of them have inclusively significant sales.

Authors:

Crisis Makers: CDS and CDO

CDS

A credit default swap, also described as CDS, is a type of financial derivative that provides an investor protection against the payment’s default.

In these types of derivatives, there is the buyer who is insured by a compensation in case of default. Usually, the payoff corresponds to the face value of the loan. And then, there is the seller who agrees to reimburse the investor in a situation of default. Most of the time, the holder of a CDS is required to pay a continuous premium called “fee” or “spread”, whilst holding the contract. The value of a CDS is determined upon the likelihood of default, as well as its demand.

 

CDO

It is also important to mention CDO’s, short name for collateralized debt obligations, when mentioning the financial securities involved in the 2008 financial crisis. These products are another type of derivatives and they are created by banks by pooling individual loans into a single product and sold to investors in the secondary market. Hence, the payment’s installments are now redirected to the investor who bought the CDO’s. They are collateralized, meaning there are assets associated with it that work as collateral in case of loan defaults. When constituted by mortgage-loans, these derivatives are called Mortgage-backed securities (MBS).

There is a variation of these instruments called synthetic CDO’s. It uses other derivatives to generate income such as credit default swaps or options, rather than mortgage loans that correspond to cash assets. The buyer takes a short position assuming the underlying assets like the CDOs or mortgage loans will default, paying a premium for the position. Essentially, the buyers are betting for the outcome of the loans. Usually investment banks or hedge funds are involved in finding the counterparty of the deal, since these instruments are not traded in the stock exchange.

 

 

The role of CDOs and CDSs in 2008

We often hear the terms CDS and CDO intertwined with the extreme economic downturn period that started in December of 2007 in the US and turned into a global recession in 2009, known as the Great Recession. The reality is that the collapse of the US housing and financial markets can be traced to the unregulated and irresponsible use of these financial instruments.

From 2001 to 2004, the US Federal Reserve held low interest rates to fight slowdown in the growth of economic activity. Simultaneously, federal policy encouraged home ownership which led to a boom in the housing market and its weight on the US economy. Mortgage debt rose at an astonishing rate at the same time as CDOs, using mortgage loans as collateral, proliferated.

Households resorted to mortgage lenders for mortgage loans with small worries about paying back since real estate prices were continuously rising. The lenders would sell these mortgages and pass the risk to investment banks who compiled mortgages in CDOs and split them in three tranches for their clients, passing on the risk. If the loan would default, the first tranche would be the first to get paid followed by the middle and the bottom, which made the top tranche safer than the middle or bottom. As it is in the financial markets, more risk was rewarded with higher return rates. Credit agencies would label the top tranches AAA, the middle BBB and would not even bother to rate bottom tranches.

The continuous rise in the housing market made the demand for CDOs very high, so mortgage lenders lower the standards for qualifying for a mortgage. In other words, these financial intermediaries attributed mortgages to households that were not credit worthy (subprime mortgages). Defaults were not a worry since mortgages would immediately be sold to an investment bank and house prices kept rising. Credit rating agencies did not downgrade these CDOs and investors kept blindly buying them until borrowers started defaulting and lost their homes. Lenders tried to sell all these houses, but since there were so many, housing values did the impossible and plunged, bursting the housing bubble and destroying the value of CDOs. Synthetic CDOs amplified the exposure of the economy to the mortgage market since they enabled infinite bets on the mortgage market and were easy and cheaper to create. Banks and financial institutions were filled with these assets and were unable to sell them, which collapsed and crippled the financial system dragging the US and World economy along.


Collapse of Lehman Brothers in 2008, Source: The Guardian

Collapse of Lehman Brothers in 2008, Source: The Guardian


 

Post 2008 Scenario

A major lesson withdrawn from the crisis was the lack of regulatory oversight over CDS, which was considered one of the main grounds for the turmoil. Therefore, shortly after the financial crisis, on July 21, 2010, as an attempt to regulate de credit default swap market, the Dodd-Frank Wall Street Report Act of 2009 was signed into US federal law by President Barack Obama, the greatest regulatory overhaul of financial markets since the Glass–Steagall Act almost eight decades earlier. The act not only phased out the riskiest CDS, but also forbade banks from using customer deposits to invest in derivatives, including swaps – Volcker Rule -, enhancing the separation of proprietary trading from commercial banking activities. Also, it required the Commodity Futures Trading Commission to regulate swaps, setting up a clearinghouse to trade and price this type of derivatives.

 

 


Sign of the Dodd-Frank Wall Street Report Act of 2009 by President Obama

Sign of the Dodd-Frank Wall Street Report Act of 2009 by President Obama

Consequently, many American banks shifted their swaps across the Atlantic to escape the strict U.S. regulation, since, although all G-20 countries agreed to introduce new legislation, most of them were still finalizing the rules. However, in October 2011, this strategy was sabotaged when the European Economic Area introduced the MiFID II, ensuring fairer, safer and more efficient markets and facilitating greater transparency for all participants.

Furthermore, in 2010, during the November Seoul Summit, leaders of the G-20 countries agreed on new bank capital and liquidity regulations – Basel III-, proposed by the Basel Committee on Banking. These new rules addressed some loopholes that had been exploited by banks, through CDS contracts. Yet, although these regulations appear to convey some degree of safety to banks, if many of their activities are taken off their balance sheets, the risk associated with their portfolios might, on the contrary, be amplified.

Also, the 2008 financial crisis aftermath meant a dry up in demand for CDOs. However, in the years following, the disappointment for the low returns of other bank vehicles reignited investors’ interest in these complex securities. Nevertheless, the environment is undeniably distinct from the scenario leading up to the “Great Recession”. Due to the tighter regulations and capital requirements imposed on these markets, lenders are far more cautious, and investors seem more reluctant when investing in these assets.

Despite the introduction of several regulatory measures on the credit default swap market two years earlier, public attention was once again focused on CDS after the large trading loss sustained by J. P. Morgan. On May 10, 2012, Jamie Dimon, J.P. Morgan Chase CEO, announced the loss of $2 billion, due to the bank’s bet on the strength of the market and, by 2014, the trade had cost the bank $6 billion. Some acknowledge the London Whale (1) case as the result of ineffective risk management, reigniting the controversies about the misuse of CDS and the need for even stricter regulations. 

A decade later, the post crisis credit market is still undergoing major structural changes and one can argue that both Dodd-Frank and Basel III are still works in progress, ultimately reinforcing the emergence of Basel IV. Indeed, the effect of such regulatory measures remains under-research, but their impact is undeniable, and the market is responding through the creation of new products, such as CDS index swaptions and CDS futures. Hence, although there is an emergent need for greater regulation and insight of the market, the development of new CDS and CDO related products gives rise to an innovative market channel full of financial opportunities, setting the tone for a whole new paradigm in credit markets.


(1) Nickname given to the trader Bruno Iksil, who was considered the responsible for the loss of at least $6.2 billion for JPMorgan Chase & Co. in 2012.


Sources: Corporate Finance Institute, The Balance, Bank for International Settlements, Investopedia, Business News Daily

 


João Ribeiro - João Ribeiro Matilde Mota - Matilde Mota Martim Leong - Martim Leong

Oil War 2020

Oil, a three-letter word that embodies the most important source of energy since the 1950s, the lifeblood of modern societies. As the main energy supply, this commodity reshaped not only the power industry, but also how we live, supplying 40% of the world’s energy demand. Therefore, oil continues to survive the constant attempts to shift energy consumption into more sustainable alternatives based on renewable sources, remaining the most-traded non-financial commodity worldwide. The fact that, nowadays, one cannot imagine a world without crude oil, and its inexistence would lead to a screeching slump in modern societies, increases its value, emphasizing its prominence in the global economy.

The United States, Russia and Saudi Arabia arise as crude oil’s largest producers and, in 2019, jointly produced approximately 33 million barrels per day, 54% of total world production. According to IBISWorld, a leading Business Intelligence company, the oil and gas sector’s revenues amounted to approximately $3.3 trillion last year, and with a 2019 Global GDP of around $87 trillion, the oil and gas drilling sector by itself represents around 3,8% of the world economy. It is evident that the 3 main players in this complex industry compete for the monopoly of one the most profitable markets, but one cannot enter this game without caution, since the oil’s biggest sharks will be ready to counter-attack.

With the world markets slowing down due to the most recent crisis caused by the coronavirus pandemic, demand on crude oil has decreased drastically, as isolation measures have tightened around the world.

The members of the Organization of the Petroleum Exporting Countries (OPEC) and the invited country Russia, gathered in a meeting concerning the market demand on the industry after the virus situation. Russia has been allied with Saudi Arabia and the organization since 2016 with the aim to balance its production levels with other countries and keep prices relatively stable.

In this meeting, Saudi Arabia positioned itself and suggested cutting production levels in order to hedge price decreases during these times. However, Putin’s nation was against the proposed measure as they believed it was too early to cut production, the organization failed to reach an agreement between the parties involved, effectively ending the partnership. Some insist that the country is availing oneself of the Asian demand to increase its market share, others agree that it wants to keep prices low to fight the American shale oil industry, which has been growing in the past years. One thing is certain, Russia is indeed worried about its market share and believes that at the moment it is better to be against the Saudis than opting to cooperate. Saudi Arabia counterstroke, announcing they would increase their production to its highest, almost 13 million barrels per day, as well as price discounts in Europe and the United States.

On the 8th of March, the prices started to tumble and the next day they plummeted more than 30%, the worst loss since 1991, and the Russian currency depreciated to its lowest since 2016. For now, the Saudi-Russian alliance is paused, and the war has begun. The Saudis believe they will be able to sustain profits, as their production costs are very low, while Russia claims the ability to sustain prices between 25$ and 30$ for several years due to its National Wealth Fund. Nevertheless, these countries will now experience a thinner margin, despite gaining some revenues alongside customers. From a game theory perspective, we are assisting a prisoner’s dilemma situation where either party may end up hurt after this move since market share will not necessarily be gained and cooperation would better position themselves.

On the 2nd April, Donald Trump claimed that a deal was expected to be reached soon and that production cuts were already in order after affirming that he talked with the leaders of both countries. This prompted a one-day rally in oil futures of 10%, but neither countries committed to supply cuts and the Russian Government denied the claims made by the US President.

On Sunday, April 5th, Saudi Arabia, Russia and other giant oil producers from OPEC made progress in reaching a deal to stem oil prices, despite the difficulty in arranging a meeting and the continuous exchange of accusations between the two leaders. This deal would also involve the US, as they became the biggest oil producer of the last years since the shale revolution and have a great impact on this industry. Together, the members would be proposed to cut their oil production by 10%, but Donald Trump has shown little willingness to do so. The US has even threatened the use of sanctions and tariffs to push the two countries to solve the conflict.

“If the Americans don’t take part, the problem which existed before for the Russians and Saudis will remain — that they cut output while the U.S ramps it up, and that makes the whole thing impossible”

— Fyodor Lukyanov, head of the Council on Foreign and Defence Policy


Source: Trading View

Source: Trading View

Energy companies are suffering the most from oil wars and this may have a damaging effect on the credit markets as well, since they have been very active in the bond market in the past decade and investors were always keen to lend more and more. This borrowing was done using junk-rated bonds and it is remarked that these companies account for 11 per cent of the US high-yield market. Being rated BB or lower, these issuers are at higher risks of default and the current oil war aligned with a decreasing global demand may cause further downgrades and raise the costs of borrowing. With such a heavy representation on the junk bond market, this shock may not stop at low-rated debt and even impact “safer” debt.

Investors reacted as they have been adjusting to the coronavirus outbreak and shifted funds for the usual safe havens. On the 9th March, the sharp oil price drop prompted a decrease of 7% in the S&P 500 in the first minutes of trade. This sell-off was accompanied by a raise in the price of gold and related ETFs and an increase in the purchase of US Treasury Bonds, represented by a decrease in the US Treasury yields.


Source: Bloomberg

Source: Bloomberg

At this stage it is quite unclear to predict any short-term agreement between both parties, however, what is clear is that current prices are bad for producers whilst being well received for consumers. What this means is that, in theory, oil importing countries will benefit from this price decrease, considering that one of their main raw materials used, became drastically cheaper. However, this benefit will obviously not be maximized due to all constraints being imposed by governments worldwide during the COVID-19 pandemic, which, ultimately will make this decrease in prices a small tool to respond to the economic impact caused by the viral disease. Furthermore, not everything is bright for importing countries. Let’s take Portugal as an example, which has Galp, which refines imported Brent oil from Brazil and Angola before selling the final good to retailers, as one of its largest companies. Galp had set an average break-even price of 25 € and is still able to sell at current prices, however, as seen in the last few weeks, its price has been right around that value, even reaching the 21€ quotation. As seen, Portugal is not a producer nor an exporter of the raw material, yet, by having companies in its manufacturing chain like Galp, is still exposed to this war that influences prices worldwide and can lead to lay-offs and even shutdowns.

On the other hand, we have the petroleum exporting countries being harmed by not only the influx of supply as the decrease in demand. Some are being forced to decrease prices while also increasing production, to not lose their market share, while others are considering a step-back in production until prices begin to rise. One example being the case of the US which produces, in mass, Shale Oil, which is more expensive to produce. Also, countries that cannot step-back due to an already unstable financial situation as Venezuela, Ecuador and others third-world countries are being dragged into a fight they just cannot handle, especially considering that, unlike Russia, they do not hold a meaningful foreign exchange reserve to back up these abnormal losses, so, debt defaults are beginning to look a reality.

The markets and investors are not happy having to deal with an oil war and a virus outbreak and, if Russia and Saudi Arabia take long to solve this conflict, Governments and Central Banks may not be able to save world economy.

Sources: CNBC, Investopedia, TIME, Bloomberg, Financial Times, Vox, ABC news

Is the Global Economy Infected? Part II

Despite the world’s biggest central banks intentions to deliver monetary policy in order to soften COVID-19’s impact on the economy, markets continue to fall sharply in an irrational manner. On the last week of February, the major financial indexes showed startling results registering their biggest fall since 2008, with the S&P 500 dropping 11%, its worst weekly decline since the financial crisis,  the Dow Jones Industrial Average crashing 12.4% and the PSI-20, the main Portuguese index, registering its worst result since Brexit.

february swoon.png


How are investors reacting?

A few stocks managed to escape the sentiment of fear by investors. Evidently biotech stocks, particularly the ones involved with the production of vaccines and antivirals, were one of the main class of stocks that rose in recent weeks. A particular example was Zoom, as investors are already pricing an expected period in which people will be forced to work from home and must use systems like the ones this company develops.

Investors quickly ran to the “safest” asset in the financial markets with US Government Bonds surging and dropping the 10-year US Treasury yields below 1%, an all-time low, also as a result of the interest rates cut by the Fed.

The yen is another traditional safe harbour being perceived as one of the most stable currencies amid market uncertainty and, at the time this article is being written, stands at 108.20 yen a dollar. Gold reached a seven-year high last week with investors using the precious metal as a haven from the meltdown in Wall Street. But, in these last few days, gold’s price plummeted with the biggest one-day decline since 2013. Gold dropped 4.5% on the 28th February as investors are selling it to cover margin calls as needs for cash arise due to the sell-off in stocks and fear is rising that China’s demand for gold is severely weakening.

However, ETF investors seem to be the exception in a week of pure panic in Wall Street. When we take a closer look at ETFs linked with the stock market indexes, we observe that the players that shifted higher amounts of cash from SPY have been institutional investors that are being faced with liquidity concerns, it was not a panic move. Another trend is the outflows from funds related to Japan who are in the frontline of the virus and shifts to European markets, for example. At the same time, with the decrease of interest rates and the continuous inversion of the yield curve, investors dumped financial ETFs like the XLF (an ETF that tracks an index of S&P 500 financial stocks) and again it was a very rational decision. Contrary to what is being seen in other markets, even amid uncertainty, there is still a strong demand for ETFs.

Short sellers on the US stock market, that predicted overvaluation and were expecting a period of correction, got a big help from the outbreak of the virus and managed to make $105 billion in a week. This has also prompted a raise in short selling since some believe the bottom has not yet been achieved.

Employees wear face masks as they stand in a reopened Apple Store in Beijing last week. Source: Associated Press

Employees wear face masks as they stand in a reopened Apple Store in Beijing last week. Source: Associated Press

Moreover, some of the world’s biggest enterprises are suffering at the hands of this illness. Dow Inc., Goldman Sachs Group and Intel, alongside Apple, were the sum of main victims as “24 of its 30 components finished in the red”. For instance, Apple expressed its concerns of not being able to fulfil its second-quarter financial guidance since the outbreak has led to a cut in the production of iPhones and the firm heavily depends on factories in Shenzhen, China, and its Chinese customers. Therefore, the American multinational technology enterprise joined the number of companies that are expected to reach the bottom line caused by this pandemic.


What are the main global institutions doing to fight the coronavirus’ economic and social shock?

Governments and Central Banks have been trying to stabilize the markets and diminish the economic effects of the virus before an increase in infection cases cause tougher impacts.

Central Bankers around the world are decreasing rates or acting to ensure liquidity in the financial markets. This support has been the cause for some rallies along these weeks, keeping investors hopeful that the effect of COVID-19 in the world economy will be diminished in some part. At the start of March, the Fed moved from hinting to making an emergency interest rate cut of half a percentage point, its biggest cut in more than 10 years. As of the 3rd of March, interest rates now sit between 1% and 1.25% as Jerome Powell states that the central bank is “prepared to use our tools and act appropriately, depending on the flow of events”. Despite this action, markets reacted negatively hinting that stimulus may make borrowing cheap, but the economic menaces come from a decrease in consumption and an infected workforce. Besides the Fed, the Reserve Bank of Australia has cut interest rates to 0.5% and the Bank of England and the Bank of Japan pledged to use every mechanism in their hands to “ensure all necessary steps are taken to protect financial and monetary stability.” Even the initially sceptical ECB joined other central banks in recognizing the threat and taking arms against it.

The People’s Bank of China was the first to cut its rates and the Chinese Government is expected to increase fiscal stimulus as worries about reaching its economic targets are surging. This fiscal stimulus will probably consist in investment in infrastructure to deter the slowing in economic activity shown in recent reports.

On the other side of the Atlantic, President Trump and the government’s health-care authorities have been releasing contradictory statements in what concerns the extent of the threat this pandemic represents. While the major figure of the United States disregards the impact of the virus, stating that the risk is low and assuring Americans that they’re unlikely to die from an infection, the CDC (Centre for Disease Control and Prevention) has publicly detailed that “an American outbreak would likely cause widespread disruptions in everyday life, including closed schools and cancelled business meetings”.

On the other hand, the Chinese power aggressively acted in order to slow the spread of COVID-19, establishing a Central Leadership Group for Epidemic Response and the Joint Prevention and Control Mechanism of the State Council. Moreover, the General Secretary Xi Jinping personally directed and deployed the prevention work, making the control of the COVID-19 outbreak the top priority of the government at all levels, closing schools and other public facilities, asking overseas Chinese to reconsider travel plans and advising citizens to quarantine. Nevertheless, the attempt to silence whistle-blowers distorts the real figures of the impact the virus has had on China.


What’s next for this pandemic?

Undoubtedly, if the virus continues to spread at this pace, its impacts will reach a greater dimension. Jobs are in danger and most firms’ supply chains are jeopardized, rocking financial markets and tumbling the global economy. Some believe the worst is yet to come. It is also important to remember that the American elections are taking place in November and may have a big impact on investors sentiments. We could see trade wars between China and the US worsening if Trump gets re-elected. The world economy is in a very tight deadlock and the next months will dictate its future outcome. Is this just a glimpse of what awaits us? Either way, not much is within our reach. So, let’s just wash our hands and wait as we watch 2020’s soap opera unfold.

Sources: Bloomberg Intelligence, Market Watch, The Washington Post, CNBC, Financial Times

Is the Global Economy Infected? Part I

The world is on red alert and has “Coronavirus” as its watchword. But what is exactly this virus that has caught everyone’s attention in the past weeks? This so-called coronavirus disease 2019 (COVID-19) is identified as a new type of coronavirus that belongs to a family of viruses that cause illness such as common cold, severe acute respiratory syndrome (SARS) and Middle East respiratory syndrome (MERS). Despite its scientific definition, not much is known about it yet. Nevertheless, its contagiousness is undeniable and, despite having started in China, according to the World Health Organization, “the number of infections outside China has outpaced those inside the country”, raising the world’s concern about the rise of a pandemic that has made, until now, 3555 victims.  Yet, another question arises: is this mysterious virus only a well-being subject? As a matter of fact, this highly contagious virus is spreading beyond healthcare fields, shaking economies and tumbling global markets.


Hit-hard industries by COVID-19

Closed stores, travel bans, or cancelled conferences are some of the measures imposed in order to combat the spread of the virus of 2020. Plenty of businesses are struggling to get back on their feet and consumers’ worries keep rising after new cases emerge. China is one of the main concerns among industries, as the virus concentration is much greater in this country and the number of stores closing and shoppers sheltering at home are increasing. However, the initially-Wuhan epidemic has now expanded far beyond the Chinese city.

The travel industry is one of the largest industries in the world, with revenues around $5.7 trillion. But now, it’s being hit by travel restrictions and cancelled trips prompting a crisis towards this industry and dragging down the global economy. The international Air Transport Association, IATA, warned that global demand for air travel could fall in as much as $30 billion in revenues, the first time in 10 years. These would correspond to a 4.7% hit in global demand levels, corresponding to a 0.6% global contraction given the 4.1% expected growth for 2020.

Many big shows have been cancelled already, in an attempt to control the outbreak of the virus. Among them are Geneva Motor Show, Facebook’s F8 conference or ironically enough the leading trade show for the travel industry itself, ITB Berlin. Many companies’ business trips are also on hold, concerned about the employee’s exposure. British Airways, Ryanair, Lufthansa and EasyJet have already been forced to cancel hundreds of flights, as the airlines industry body has already warned of a falling number of passengers. Some of them are resorting to price cuts on short-haul flights, in order to dodge demand breaks.

In the tech industry, companies are already sensing the damages being caused by COVID-19 as well. The first ones being those with direct exposure to China, the supply chain of which is so dependent on this country, causing several companies to have issued a financial warning regarding the consequences of the pandemic.

Moreover, shortages in supply are expected in various products ranging from smartphones, headsets or even cars. The manufacturer Foxconn, known to be the main assembler of Apple, has stopped almost all of its production in China, who’s accountable for 75% of the production capacity of the firm. Foxconn’s revenues are down 10% compared to last year’s period. The disruption in the company’s operations has prompted questions regarding the dependence on this geographic location.


Why can this affect the global economy?

The reason is simple: China. Bear in mind that we are talking about the second biggest economy in the world and the world’s largest manufacturing and exporter of goods. Besides losses in China due to decreases in consumer spending and stores closing, the impact will extend beyond the Wuhan province.

Since the outbreak of the COVID-19 virus, there has been a tremendous amount of stoppages and even lockdowns in China’s factories, as only about 50% of them haven’t yet been harmed by the spread of the virus. This not only affects production, but also sales, since people are forced to stay at home, hence, not spending money on a wide variety of products. Furthermore, sales in China are not the only ones doomed to failure this first trimester, as sales in a lot of different sectors outside China are now compromised due to the disruption of supply chains created by all the lockdowns that have been occurring. So, basically, any company directly working with China, as for raw materials or any work in progress goods, is most likely being impacted since, a lot of companies in Europe and the United States are receiving their orders with weeks of delay and some of these can’t even sail through the Ocean due to requirements of a minimum amount of goods to fill the ships, which are simply not coming through.

View fullsize


pasted image 0.png

By looking at the Purchasing Managers’ Index (PMI), we can understand how severe the coronavirus has been to China’s economy given the fact that in 2008’s global recession this index had hit a low of a 38.8 score (to provide some insight, any score below 50 shows that there are more purchasing managers, in the manufacturing sector, indicating a contraction in this sector). Besides this concerning value, the IMF stated that the global spread of COVID-19 will damage economic growth for 2020. After the easement of the US-China trade relations, growth for this year was expected to surpass 2019 , whereas now Global growth in 2020 will dip below last year’s levels, but how far it will fall and how long the impact will be is still difficult to predict as the Managing Director of the IMF Kristalina Giorgieva said last week. This means a revision of 0.4% or higher compared to the values expected in January.

Although it is to be known at what extent, we can definitely agree that COVID-19 is taking a toll on the economy and may even have lasting effects in our lives. What remains to know is how Governments and Central Banks will react and how are investors limiting losses and even making gains during this period.

Sources: Bloomberg Intelligence, Market Watch, The Washington Post, CNBC, Financial Times

A Step Towards a More Sustainable Financial Market

Undeniably, society’s concern about being green has been growing tremendously for the past years and environmental awareness is, certainly, one of the burning issues of the century. Consumers are changing their behaviors, opting for sustainable products and making more aware choices. However, is replacing a plastic bag for a paper one the only way of being green?

12 years ago, the European Investment Bank issued the first ever Climate Awareness Bond (CAB). These green bonds are designed to encourage sustainability and to support not only climate related but also other types of environmental projects. Backed by the issuer’s balance sheet, these sometimes called “climate bonds” are intended to fund projects that are environmentally friendly, going towards new or existing projects that are meant to have positive environmental or climate effects, supporting sectors such as renewable energy, transport or waste management.

“Green bonds offer investors the option to diversify their portfolio by not only income-based decisions but environment-based ones as well.”


This market works as a common bond market, in which borrowers are institutional investors trading their financial assets. Companies, local, state and national governments and supranational institutions ensure the lending of this eco-friendly project, representing the supply side of a growing market that has, nowadays, more than 50 issuers.

The field of action is large, involving several sectors of the economy. For instance, in June of 2013, Commonwealth of Massachusetts, as the North American pioneer in this field, sold green bonds amounting to $100 million and publicly shared which projects are being financed by green bonds and how does society benefit from the investment in this innovative financial asset. Being the main market supplier, the US, led by the mortgage giant Fannie Mae, plays an important role promoting this environmentally friendly financial asset and, since Poland opened the sovereign market in 2016, France, Belgium, Ireland and the Netherlands did not take long to follow the example of Uncle Sam’s country.

Throughout the years, the green bonds’ market has been experiencing a boost of investors looking for conscientious choices to allocate their funds. According to Bloomberg, until 1st October 2019, “assets under management at 644 funds focused on environmentally friendly investments stand at more than $220 billion, compared with around $80 billion at the end of 2014”. Also in the past month, George Ammond wrote for the Financial Times, concluding that Asia-Pacific issuance of green bonds had hit a record of $18.9bn. This value was raised from 44 green bond issuances that were open to international investors, which positively correlates with the growing interest from investors in green finance.

global+green-bons+sales+across+all+currencies.png

Moreover, this green investment method has revealed to be beneficial for both parties: sellers and investors. The first ones benefit from the eco-friendly vision of the investment which is propitious to attract new investors, resembling almost to a marketing strategy and drawing the attention of the most concerned consumers. The second ones benefit from the fact that these financial assets are characterized by having tax-exempt income. Additionally, investing in green bonds enables buyers to monitor these projects, contrarily to the very little insight investors have into what happens with the funds raised on debt capital markets.

However, a major dilemma arises. Are these “bonds for the planet” truly used to start and develop eco-friendly projects or are they just part of a bigger marketing strategy?

As previously mentioned, green bonds have tax-exempt income, they are supported and sponsored by governments, what closely fills the expectations of environmentalists in trying to solve climate change problems. What about the cases in which green bonds are issued to promote other projects that are not so “green” and institutions still benefit from all of these advantages? Firstly, it depends on the perception of green. This broad concept can differ not only internationally but also nationally, making it difficult for issuers to comply with both standards. Moreover, the lack of a “standard universal certification system” allows for green bonds not to be analysed through a universal procedure that accounts for the borrower’s creditworthiness or “greenness” of a bond. For instance, China is the biggest carbon emitter and occupies the second position in issuing green bonds. The problem started when the chinese power used this concept to finance coal-burning plants which, even if less polluting than previous methods, don’t reduce the carbon emission in the long-run. Another dilemma, pointed by Boardman, the chief financial officer of clean energy developer Sindicatum, comes with the lack of benchmarks that causes green bonds not to “qualify as a mainstream investment vehicle.”

“I think we need to think differently, we need governments to sit down and say all finance has to be green. There has to be strong incentives, clarity over the status of green bonds, status of green loans and bank financing.”

— Michael Boardman

In an attempt to clarify this problem, several studies were conducted aiming to broaden the definition of “green”. Oslo-based Cicero (Center for International Climate Research) came up with the idea of using three shades of green according to the ecological impact of the project in question: dark green, for projects reducing the carbon emission in the long run (wind energy); medium green, for projects that take a good step forward; and light green for steps that won’t change the long-term outlook on their own, consisting in more efficient projects (China’s case).

Indeed, in the mesmerizing bonds’ market, if an investor understands the environmental risks better, the cost of capital will go down for green projects. The benefits this financial asset brings to the environment have evidently been shown. However, in order to really create an impact on sustainability, this market has to grow much more than the observed heretofore. Massive investments are required to change the way we produce energy, reinforcing the urgency for individuals to take a proactive approach against climate change. As an “idea that captures investor imagination to combine the force of capital markets for a good end”, green bonds arise as a “tool to reconnect the dots between finance and the real economy”. What determines the effect of this revolutionary financial asset not only on the environment, but also on society, is how institutions and companies incorporate and allocate these green investments and in which degree are individuals incentivized to engage in an eco-conscious behavior. It is crucial to acknowledge that ecological progress is not simply imposed on society, but rather a consequence of conscious and informed choices by society’s decision makers and green bonds are certainly an important step towards a more sustainable financial market.


Sources: S&P Global Report, Bloomberg, European Investment Bank, CNBC, Dealogical Data, The Financial Times, CNBC.


Madalena Nunes - Madalena Nunes Matilde Mota - Matilde Mota

Making Money in a Recession

Despite not agreeing exactly when will the next recession hit, most economists agree that it isn’t far in the future. The longest Bull Market is coming to an end, so investors should transform their portfolios to gain or reduce losses during the next economic downturn. The options are diverse, and we tried to narrow them down to the most common and effective.

Short selling

Everybody has heard of the renowned movie Big Short and how rich Michael Burry and Steve Eisman (known in the movie as Mark Baum) got, but few understand what a short sale is.


Michael Burry: The genius behind the Big Short Source: CNBC
Michael Burry: The genius behind the Big Short Source: CNBC

This investment mechanism consists in selling an asset or stock that the investor doesn’t own. Anticipating a price decline, an investor sells the previously borrowed securities having to return the same number at a later date, meaning that he intends to sell when the price is high and buy back when the securities are cheaper. The lender of the securities is the broker-dealer that the investor relies on to place a sell order. This trade is made on the margin and is leveraged, meaning an investor can make much more money than the amount of the securities, but it also represents a risk if the price increases instead of declining. This type of investment requires that 150% of the value of the securities stays in an account.

Due to its risks and margin requirements, short selling is not adequate for amateur investors or small investors due to its raised expenses: costs of borrowing the security to sell, the interest payable on the margin account that holds it, and  high trading commissions.

In times of recession, short selling poses high returns, particularly for experienced investors that predict Bear Markets before they happen. Overpriced securities are the most targeted by short sales since they fall the most in an economic downturn.

Gold

Gold has been perceived has a safe haven investment for hundreds or even thousands of years, especially in times of uncertainty in the financial markets similar to the ones we live today.

Historically it has always been used as a physical store of value due to its rarity and traded back and forth to protect value in times of war, recession, political turmoil, etc. Since gold cannot be printed and its price is resistant to changes in interest rates, gold has tended to maintain its value throughout time.

When we compare it with stock indexes (S&P 500 or Dow Jones Industrial Average), it is evident that the price of gold has continuously increased, but with much lower variations. Another aspect that stands out is the negative correlation between stocks and gold notably in times of recession: in the Dot Com Bubble in the 2000’s and in the Subprime Crisis of 2008, investors withdrew their money from stocks and stockpiled it in gold and gold derivatives. This last statement can be verified in the graph when the stock market takes a dip, gold prices raised especially before and during periods of recession. 

But how do we invest in gold? The easiest way is to buy physical gold or goods made using this rare mineral, like jewellery or coins, in the private market. But the amount we can buy this way is very limited and may not be correctly priced. Therefore, to bet on the variation of gold’s price or of other physical commodity in the public market, an investor can buy/sell Gold Futures, ETFs, Mutual Funds or stocks belonging to Gold Companies.

Even during bull markets, gold-related assets are essential in a well-diversified portfolio to guarantee stability and steady returns.


Variation in Dow Jones Industrial Average (Blue) and Gold’s Price (Orange) Source: Macrotrends
Variation in Dow Jones Industrial Average (Blue) and Gold’s Price (Orange) Source: Macrotrends

What are consumer staples?

Consumer Staples are everyday used products by households that will continue to be used regardless of their cost or the state of the economy. These types of products are unlikely to be cut from any individual budget as the consumer is unable or unwilling to do so. The level of demand on these products tends to be rather constant. Consumer staples go from foods, beverages and drugs to basic household goods like hygiene products.

These type of good are less volatile during economic cycles (non-cyclical) due to its high demand and level of utility, revealing its constant level of demand. Hence, sales and earnings growth in the consumer staples sector tend to remain constant both in good and bad times. Price elasticity of demand is very low, as the demand in this type of product doesn’t react much from changes in the prices of these goods.

What are utility stocks?

Well, utility stocks are stocks related to firms in the Utility sector, a sector in which companies provide basic amenities such as gas, water, electricity or even renewable energies. Investors often include these types of stocks in their portfolio due to their relative stability. Thus, like consumer staples, these utility goods are less volatile during economic turmoil due to their necessity and utility provided.

Utilities are often associated with stable and consistent dividends and the betas of these type of companies are usually less than 1 due to their ability to be less volatile than the equity markets. Hence, during economic slowdowns or even recessionary times of the economy, utilities tend to perform well under these hard circumstances. However, in the opposite case of an expansionary period, utilities might be stocks that will underperform the average. Not only because of the beta’s value but also because utility companies usually have high levels of debt (due to infrastructure needs) and during economic improvements, interest rates increase and investors are able to find better yielding in other alternatives such as Treasury bills. Therefore, utilities perform well under economic slowdowns since interest rates decrease and the yield related to utility stocks is greater than the risk-free assets.

What are healthcare stocks?

Healthcare stocks are stocks in this case related to firms in the Healthcare Sector which consists of businesses that provide medical services, manufacture medical equipment or drugs and/or provide medical insurance to patients. In the U.S., the healthcare sector is one of the largest accounting for one fifth of the total annual GDP. Healthcare services are associated with highly price inelastic meaning changes in prices have a little effect have on the quantity demanded.

Holding an all-stock portfolio such as the S&P 500 index fund can be improved by simply adding a value-weighted healthcare portfolio, resulting in both a higher return and a lower standard deviation (diversification-effect). Healthcare stocks were the strongest performer in this index in 2018. However, this sector is becoming more volatile with the slowing of corporate earnings, trade wars and rising interest rates.

ETF

An Exchange-trade fund is a security made of a basket of different securities combined in a single entity, which then gets traded like an ordinary stock in the major stock exchange markets.

The ETFs generally can track an infinite range of benchmarks, from commodities to every possible stock, with the purpose of getting has much return has possible in all the different segments of the markets chosen. They are most usually focused on the same type of security and so they can be characterized as Stock, Bond or Commodity ETFs. 

To invest in an ETF, you first need to choose the benchmarks you are willing to risk your money on as the economies they’re in, while also bearing in mind the proportion each company takes on that ETF.

ETFs have its pros and cons which, on the good side, offer horizontal diversification of securities and transparency, since with the help of the internet we can see its true value based on what’s inside of it, but on the other side you have trading costs related with expense ratios and commissions to brokers and the fact that very specific ETFs may not have high demand levels, making it harder to sell it in the short-run and so, less liquid.

Some of the most well-known can be the SPDR S&P 500 ETF that replicates the famous S&P 500 index, which is the general overlook of the biggest 500 public companies in the world, the SPDR Dow Jones Industrial Average ETF and the Invesco QQQ, which also track the Dow Jones and the Nasdaq-100 indexes, respectively, both providing the industrial and technological overlook of the US economy. These three ETFs have positive correlations with the evolution of most relevant global economies and so, they deal with a great variety of market segments, making you invest not in any particular benchmark but in an economy, which is not the case for the majority of them.

REITS

A real estate investment trust (REIT) is a corporation that owns and manage income-producing properties

They can be characterized in three different ways, them being:

  • Equity REITS

It is the most common one, which owns and manages real estate directly, being the revenues from the leasing and rents of tenants the primarily form of income and not the reselling of portfolio.

  • Mortgage REITS

It is mainly focused on financing real estate and the revenues are generally made by what’s earned from the interests of those mortgage loans. Also, they invest in and own residential and commercial mortgage-backed securities for their portfolios.

  • Hybrid REITS

It performs both equity and mortgage operations.

REITS can either publicly traded or private whilst the traded ones provide more liquidity to the investor than the private ones.

Investing in REITS may have its risks and most of them are directly related with the real estate current market: if property assets start to lose value, their investor will be harmed with that.; the volatility of interest rates, given that a decline in them will consequently give an opportunity to decline as well the assets rate of return; and the fact that real estate isn’t a liquid asset; However, this market shows that real estate tends to appreciate over time. In most cases there are steady flows of income from tenants if the properties are being rented and that in the long-term real estate tend to be quite profitable.

US Treasury Bonds (T-Bonds)

A US Treasury bond (T-bond) is a government debt security that ranges from 10 to 30 years maturity wise and it is known to be one of the safest investments worldwide.

The US Treasury has been around since 1776 and not once has failed to pay its lenders. Also, given that this security is backed by the “Full Faith in Credit“ clause of the United States, it faces a default risk of almost nothing, so, if the main goal to invest is to not lose money, then they are the right security to invest.

However, although being acknowledged as a risk-free asset, there are still some factors that need to be accounted before investing in it.

  • The Opportunity Cost

Considering T-Bonds are evaluated as AAA assets (risk-free), then, that will have an effect on its yields, which will consequently be lower than other potentially profitable assets with higher defaulting risk. The urge to not lose any money may let investors ignoring other safe and with high returns investments.

  • The Inflation Risk

If the T-Bond is not linked with a TIPS (Treasury Inflation-Protected Securities), the inflation risk must be acknowledged by the investor. For example, if the security provides a return of 3% and 5% inflation is occurred, then the investor will come out short since the return is not keeping up with inflation.

  • The Interest Rate Risk


Picture15.png

If the investor hopes to hold the bond until its maturity, then this risk does not need to be accounted. However, if that is not the case, then the investor may have serious problems to liquidate its investment if the Fed decides to increase the interest rates. This happens because, if new bonds are being issued at higher levels of return, then the demand for the original ones will fall causing the price of the bond to follow that same direction.


Martim Leong - Martim Leong Francisco Nunes - Francisco Nunes

João Ribeiro - João Ribeiro