As the medical community rushes to find a cure, or at least a containment, for the spreading coronavirus, financial markets: Investment Planning Assignment, UM, Malaysia

University Universiti Malaya (UM)
Subject Investment Planning
  • Investors Are Piling Into Stocks and Bonds. A ‘Twin Bubble’ Could Be in the Making

As the medical community rushes to find a cure, or at least a containment, for the spreading coronavirus, financial markets figure they have been inoculated against risk by the repeated application of a tried and trusted palliative: lots of easy money

Stocks and bonds continue to rise, just like the numbers of those afflicted by the virus, in a manner that raises suspicions about underreporting, as Lisa Beilfuss observes in this week’s Economy column. None of that matters to investors in an era of interest rates below zero, either absolutely or after taking into effect the loss from inflation.

That most dramatically includes bond funds. Despite paltry yields, highlighted by the benchmark 10-year Treasury under 1.60%, they poured a record $23.6 billion into fixed-income mutual funds and exchange-traded funds this past week, according to data tracker EPFR. At the current pace, investors are pumping cash into bond funds at a $1 trillion annual rate, notes Bank of America. And they’re doing it without much apparent regard for valuations or risk. Not that they’re fleeing from equities; far from it. EPFR data show another $12.5 billion going into stock funds in the latest week. Investors have been pumping up “twin bubbles” in investment-grade bond and technology stock funds, BofA observes. That’s part of the widely popular “barbell strategy,” using lower-volatility, dividend-paying stocks, such as consumer staples and utilities, as a counterweight to the riskier mega-cap technology stocks that have propelled the major market averages to record highs

To one prominent investment professional, all of this suggests denial by investors about the impact of the coronavirus. Scott Minerd, a chief investment officer of Guggenheim Partners, suggests that China’s gross-domestic-product growth could be slashed from the current 6% annual rate to minus 6% in the current quarter

To be sure, that is by far the most extreme estimate of the impact on Beijing’s economy. And supply chains affecting the production of goods bound for the rest of the world would be affected only if China’s quarantines and shutdowns extend more than two weeks beyond the Lunar New Year holiday, which ended officially on Jan. 30 but has been extended by Chinese authorities. That said,
“even if the virus does not turn into a pandemic, to think it isn’t going to impact what’s going on in the world is irrational,” Minerd writes in a client note.

Irrational optimism about dealing with the disease has given rise to cognitive dissonance among investors, he continues. Reducing risk might mean underperformance, a potential career-ender for portfolio managers. To maintain returns, investors are flooding into bond ETFs. The problem, Minerd explains, is that the prices of these funds’ component securities frequently aren’t set by the market, but by pricing services using often-stale data. That means there is no actual price discovery for the underlying bonds, which may not even trade. In contrast, the stocks in equity ETFs trade actively and continuously, allowing arbitrage to keep the ETFs’ prices in line with their portfolio values.

The indiscriminate buying in the fixed-income market “will eventually end badly,” Minerd asserts. Things are crazier than before the mortgage crisis in 2006 or the high-yield market in 1997, both peaks in valuations for those sectors before they subsequently ended in tears, he concludes.

Yet that’s not how the markets these days are seeing risk, either from the coronavirus or simply babelicious valuations. The market’s mantra seems to be the same as that of my mother: This, too, shall pass. But she was the Cleopatra of her day, the queen of denial.

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Investors seem inclined to listen to her. BTFD, for buying the dip (with a certain modifier omitted), is the other market mantra. Every decline is an opportunity, experience has shown, as long as monetary authorities keep providing the massive liquidity that justifies the valuation of anything that provides a positive return.  Even with the prospect of cratering Chinese GDP in the current quarter, China bulls say it’s time to buy, based on the low valuation of that market. While the outlook is certainly positive for the next decade, it might not be over the next few months. Which means there’s no rush to buy.

Perhaps some of the massive sums being plowed into bond funds are being earmarked for future deployment in riskier, but more promising, assets, such as emerging markets, once the global uncertainty clears. At the same time, another danger—the increased scrutiny of Big Tech from Washington—is being all but ignored by investors, as Eric Savitz writes in this week’s

Away from the headlines, there are signs that the worst risks may be priced into the markets. Energy and metals prices, key barometers of the global economy, rebounded this past week. That’s in contrast to backward-looking indicators, such as January’s soft industrial production and retail sales. And for two-armed economists, the labor market shows strength in terms of historically low unemployment claims, but also a dip in the Job Openings and Labor Turnover Survey, or JOLTS, numbers.

Amid all of the uncertainties besetting investors, easy money is making it more painful to be out of the markets—equity or fixed income—than to be in them, despite their rising dangers.

  • In view of the current market situation, you are required to answer the following questions.
  1. Discuss the reason why investors are pumping in cash to the bond funds regard for valuation or risk?
  2. What could possibly go wrong if investors continue buying in the fixed income market? (you may give example by referring to the previous incident. Eg. past financial crisis).
  3. Assuming you are a professional fund manager, what will be the best investment strategies that can be adopted to assist clients to invest their money at this point in time? (Guideline: Geographical areas, asset classes, sectorial play, etc)

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