Coronavirus, capital markets, and Soros’ theory of reflexivity

Amid the gathering storm, it is worth asking why it took so long for coronavirus to make its impact on the capital markets and, more important, what will happen next.

It’s all in the mind, according to the theory of reflexivity, developed by hedge fund manager George Soros. And that’s the worrying bit. 

In essence, market participants ignored coronavirus until the second half of February, because the implications of its spread were too awful to contemplate.

The delay was able to support prices because market behaviour always depends on the extent to which traders and investors buy into the real world.

The coronavirus crisis follows a decade during which investors willingly bought into the argument that central banks, led by the Federal Reserve, would provide the market with enough liquidity to stop another credit crisis

Discrepancies develop between the two because investment decisions are subjective in nature, reinforced by price movements as well as the stories people tell to justify their actions.

According to Soros in his book, The Alchemy of Finance: “I envision reflexivity as a feedback loop between the participants’ understanding and the situation in which they participate.”

Facts on the ground certainly influence the process but groupthink matters more.

Every market transaction develops the narrative as prices change, and further analysis enters the matrix, as investors and their advisers justify their decisions.  Their views and changing prices influence the next transaction, which has an impact on the one after, and so on, and so forth. 

Random factors cancel out. Active managers claim to root their decisions in reality but the majority of them buy into underlying sentiment for fear of suffering poor short-term returns. 

Their portfolios go on to shape their viewpoints, making it all the harder for them to take new facts on board. According to Soros: “Once you identify with your portfolio, your survival is at stake.”

Over years, a dominant narrative becomes entrenched, allowing prices to drift far from reality.

Soros does not believe in efficient markets because people are inefficient in the way they use information. They do not have access to the full story; they are too rushed to process data, or they choose to ignore the parts they don’t like. Anything to avoid losing money.

Quantitative investment is better with data. But computer programming can go askew. Quant strategies often fail to take account of sharp changes in underlying market conditions, as we saw during the credit crisis.

Macro hedge funds play a big role in changing the paradigm because they are prepared to bet large sums on stretched prices reverting to reality. 

George Soros shot to fame by making $1 billion from a short position in sterling in 1992.

At that time the European Exchange Rate Mechanism required sterling to shadow the German mark. The popular belief was the ERM was durable. But Soros was less sure. 

He hiked his short position in sterling to an astonishing $10 billion in September when Helmut Schlesinger, head of the German central bank, said he wanted to end the link with sterling. Soros knew the distance between perception and reality had become so large that this would increase pressure on the pound to impossible levels and make him a fortune.

Bets driven by reflexivity pushed returns for Soros’ $25 billion Quantum Fund to 20% a year over the 40 years to 2011 when he returned money to investors and turned it into a family office, for regulatory reasons. 

He is said to be worth $8 billion after giving $32 billion to libertarian causes through his Open Society Foundations, where his son Alexander is deputy chairman. He probably won’t be missing the anxiety and the back pains reflexivity brought him.

The coronavirus crisis follows a decade during which investors willingly bought into the argument that central banks, led by the Federal Reserve, would provide the market with enough liquidity to stop another credit crisis.

This happened as recently as 2019, during a funding crisis for the repo lending market which plays an essential role in money transmission. 

Surplus liquidity also encouraged investors to back tech-driven growth opportunities, which stoked stock market, private equity and venture capital opportunities. It pushed perceptions further from reality than normal, as value investors failed and growth investors triumphed.

With these bets in place, investors chose to believe the coronavirus outbreak in China could be contained.

But when coronavirus outbreaks in Italy and Iran appeared, and spread rapidly, from 20 February, investors had no choice but to focus on a new reality. 

Rather than growth opportunities, investors are dwelling on the impact of sickness, quarantines and anxiety on the fabric of capitalism. The world is facing a shock to supply chains, as well as demand, it appears. You don’t often get both at once and talk of a new credit crisis has been rekindled as liquidity flows in new directions.

Credit Suisse analyst Zoltan Pozsar has warned of severe risk to money transmission as supply chains break and dollars get squirrelled away into US Treasury bonds. He says the Fed should use its balance sheet to provide open-ended support.  

Elsewhere, Saudi Arabia has helped industry by pumping up crude supplies, but the new normal prefers to focus on a damaging breach with Russia.  A bearish environment often leads to conflict.

Hopes of reviving the old narrative came and went in early March, when the G7 met to consider a rescue and shares rallied, only to subside when nothing emerged.

It is just possible that the authorities will provide enough support to the market to reverse the developing narrative, helped by falling infection levels in China. A decent vaccine would help.

But time is running out, as bets are being made which will result in a new, rather bearish, paradigm unless they are reversed.