VIP: CIG Asset Management Update: “Beware of Tail Risks”

Commentary:

The U.S. Dollar, as measured by the U.S. Dollar Index, strengthened +2.9%[ix] in February 2023 and contributed to losses in gold, crude oil, and international equities – all are dollar-sensitive investments.[x] Emerging markets equities, represented by the MSCI Emerging Markets Index, lost -6.5%. The S&P 500 Index fell -2.4%, and Fixed Income, as measured by the Bloomberg U.S. Aggregate Bond Index, fell -2.6%.

Until the recent bank failures, markets appeared relatively calm on the surface, but many additional outsized potential risks remain lurking just below. In our risk-balanced approach to investing, we seek to avoid the big risks that could be detrimental to our clients’ financial well-being. Like a sherpa guiding a group of climbers up the mountain, we do all we can to avoid the hidden crevasse where, if one is not extremely diligent and cautious, a wrong move could lead to a very negative outcome.

We call these “very negative outcomes” tail risks which are defined in the industry as the chance of a large loss due to a rare event. Noted mathematical statistician, investor, and writer Nassim Nicholas Taleb has described this risk as a Black Swan – “a highly improbable event with three principal characteristics: It is unpredictable. It carries a massive impact, and after the fact we concoct an explanation that makes it appear less random and predictable than it was.”[xi] In addition to looking out for more instability in banks, we are currently keeping a diligent eye on four different areas with low probabilities but have the potential for some very troublesome outcomes – Option Market Risk, Higher Interest Rates, Student Loans and Geopolitical Risks.

Option Market Risk
The daily value of U.S. equity options set to expire at the end of the trading day, so called “zero date to expiry options” (0DTE), has suddenly risen to about $1 trillion according to JPMorgan strategist Mark Kolanovic. These extremely short-term options are highly speculative bets on stocks and now make up over 40% of the total dollar volume for S&P 500 listed stocks – three years ago they were only 15% of total volume.[xii] JPMorgan analysts Peng Cheng and Emma Wu wrote in a note that the estimated market impacts from unwinding of 0DTE options quickly could pose a potential risk to market stability and result in a decline that could eclipse the Black Monday Crash of 1987, where the S&P fell -20.5% in a day. According to JPMorgan, if the S&P 500 fell -5% in five minutes, it could trigger $30.5 billion in 0DTE option trading that could add an additional -20% to the index’s decline. If the S&P 500 fell between -1% and -5% in five minutes, it could translate to an additional -4% to -8.1% decline.[xiii] In 1987 it was portfolio insurance products that exacerbated the market’s decline.[xiv]

Higher Interest Rates
The average 30-year fixed mortgage rate was 7.06% as of the week ending March 3, 2023.[xv] One year ago, a home buyer could borrow at 3.76%.[xvi] A current home buyer with a $200,000 mortgage will have a monthly payment of $1,339 versus $927 if he purchased the house a year ago, or $4,944 more per year![xvii] Federal Reserve Chairman Jerome Powell in his testimony to the Senate Banking Committee on March 7 said that interest rates are “likely to be higher” than previously anticipated.[xviii] How will higher mortgage rates affect the critical March through June season for the housing market, when 40% of existing home sales typically occur for the year?[xix]

Student Loans
In March 2020, COVID-19 lockdowns negatively impacted the U.S. economy. Student loan payments were suspended and the government paid the interest on the deferred student loans. In November 2022 these deferrals were extended for the eighth time into the summer of 2023. The Supreme Court is currently hearing lawsuits challenging a plan by the Biden administration to cancel up to $20,000 debt per student. Repayment of student loans is now scheduled to resume either 60 days after the lawsuits are resolved, or 60 days after June 30, 2023, whichever comes first. The deferral could stretch into August, or it could end sooner if the Supreme Court acts swiftly.[xx] 10.75% of student loans were 90+ days delinquent before the deferral program began. In Q4 2022, this percentage has plummeted to only 0.87%. At the end of 2022 there was $1.6 trillion of student loan debt outstanding.[xxi] According to Forbes, the average monthly student loan payment is $393.[xxii] What will happen if borrowers need to resume monthly loan payments? Will delinquency rates soar back to pre-pandemic levels and lead to over $160 billion of student loans 90+ days delinquent?

Geopolitical Risks
Russia: We believe the fragile state of international affairs continues to be underappreciated by the markets. February marked the one-year anniversary of Russia invading Ukraine. Billions of dollars of military aid continue to be sent to Ukraine as the war rages on. Russia has warned NATO members of the threat of a major escalation if heavy weapons such as tanks and long-range missile systems are deployed to Ukraine. In January, President Biden announced he would send 31 M1 Abrams tanks to Ukraine. On February 23, Army Secretary Christine Mormuth said, “We’re looking at what’s the fastest way we can get the tanks to the Ukrainians.” Mormuth continued, “None of the options that we’re exploring are weeks or two months. There are longer timelines involved, but I think there are options that are less than two years, less than a year-and-a-half.”[xxiii] Will Ukraine be able to continue to defend against Russia’s attacks without tanks, and how will Russia respond once NATO tanks are on the battlefield? Currently the risk of the Ukraine/Russian conflict spreading to NATO member countries is low, but it would likely offer a very negative outcome should it occur.

China: China/U.S. relations worsened after the United States shot down a Chinese spy balloon on February 4. U.S. Secretary of State Antony Blinken warned China on February 28, “We will not hesitate, for example, to target Chinese companies or individuals that violate our sanctions, or otherwise engaged in supporting the Russian war effort.”[xxiv] On March 7th, In his first public comments as China’s new foreign minister, Qin Gang said, “If the U.S. does not hit the brakes but continues to speed down the wrong path, no amount of guardrail can prevent derailing, and there will surely be conflict and confrontation.” Qin also defended China’s friendship with Russia, saying the ties between Moscow and Beijing “set an example for global foreign relations”. He continued, “With China and Russia working together, the world will have a driving force. The more unstable the world becomes the more imperative it is for China and Russia to steadily advance their relations.”[xxv] In early 2022, Beijing ordered a comprehensive stress test to study possible implications of Russian-style sanctions on its economy.[xxvi] China bought 77 tons of gold between November 2022 and January 2023, its first reported purchases since 2019. These purchases were likely made to move out of U.S. dollars after the SWIFT payment system was used to impose sanctions on Russia.[xxvii] Is China preparing for an eventual invasion of Taiwan? The Carnegie Endowment for International Peace reported that some in the U.S. intelligence community believe an attack could come as soon as January 2024, around the time of Taiwan’s elections.[xxviii]

Market history has taught us to be very careful. We are focused on illuminating potential blind spots such as those above as we attempt to manage the risks of the market in our efforts to protect and grow clients’ assets. We scenario plan – we don’t forecast the market – meaning we are cognizant of the possibility of both continued upside and significant declines.

We are hopeful that none of the above risks come to fruition, but we are conscious of them and are watching closely as events unfold. We continue to have an overweighted allocation to gold and gold miners in our strategies as worsening geopolitical risks, inflation and possible longer-term risks of stagflation make gold attractive to us. Overall, we continue to stay the course of risk balanced investing – take enough risk at this part of the market cycle to reach your goals but not much more. We remain focused on striking the right aggressiveness versus defensiveness in client portfolios given the evolving uncertainty in the markets, the economy, and geopolitics.

We would welcome the opportunity to connect with you via voice or email to discuss how active oversight of market and economic conditions could protect your portfolio during uncertain times. Please reach out to Brian Lasher (blasher@cigcapitaladvisors.com) or Eric T. Pratt (epratt@cigcapitaladvisors.com).