February 07, 2020
The narrative about a stabilising global economy was in motion. The US-China trade dispute was no longer ricocheting through markets. The earnings season was expected to proceed calmly. But the three weeks since our last Asset Allocation have been a white-knuckle ride for investors, with coronavirus overshadowing all of these supportive factors. Now bulls and bears are once again at a clash of opinions and investors are asking should I stay or should I go into the market?
The Macro Picture
The first business days of the month bring a slate of eco releases, including survey data gauging general sentiment in the corporate world. Those released early February, conducted before the arrival of coronavirus, illustrated that the global economy had been faring well: The US manufacturing ISM came in at a solid 50.8. China kept its head above water with a Caixin Manufacturing PMI of 51.1 (expansionary territory), while the Eurozone equivalent appeared to be on a slow march towards 50 (reaching 47.9 in January, up from 46.3 in December). Germany, which has been the sick man of global manufacturing, saw its reading rise to 45.3 (from 43.7 in December) with companies upgrading expectations for the year ahead, seeing brighter prospects for international sales.
However, the story of a modest recovery in global growth is now overshadowed by the immediate downside risks generated by the coronavirus.
In trying to contain the spread of the virus, China has proactively quarantined some 40 million people. It is safe to say that widespread factory closures and travel disruptions will put a dent in the country’s near-term economic readings. The same is likely for the halo of emerging markets that rely on China as a growth driver.
At this stage, to predict the impact on the global macro picture would be a bit of a fudge, especially while the number of new infections has not peaked. There aren’t many comparable episodes to base assumptions on – the 2003 SARS outbreak was similar, but the contexts are chalk and cheese. A lot has happened in the two decades since then: medical technology has improved tenfold, and China now plays a much more important role in the world economy, being inextricably linked to global supply chains.
Furthermore, communication has evolved from basic text messaging to 24/7 connectivity. Markets are moved by fear, and today fear has its own express highway around the world: Social media. At the same time, eco data could potentially be less impacted, as people no longer have to leave their homes to consume. Almost anything is available online. For example, the closure of casinos in Macau means that Philippine online gambling sites are having a heyday.
All this is to say that we prefer to wait, rather than guesstimate the macro impact of the disease.
Markets are yet to absorb the full economic effects of coronavirus and thus, equities are vulnerable to more negative headlines. This is exacerbated by the fact that the outbreak came right in the middle of a mini-cycle with lofty valuations, which could easily be derailed. Due to significant estimate revisions, the earnings season has not disappointed, but has hardly been overwhelming. At the time of print, 45% of S&P 500 companies had reported – 69% of these produced a positive surprise, but the extent of the surprise (1%) is weak and below the historic average.
We don’t think this is the beginning of the end for bulls. However, in response to the perennial question – should the dip be bought? – for now we say wait. Looking back on SARS, EBOLA and other such epidemics, markets recovered when new infections peaked. But coronaviruses are complex; they mutate while they replicate, so it’s impossible to divine when the virus will be brought under control. Although we aren’t increasing our positioning, we also aren’t reducing it, noting that by the time the SARS outbreak had peaked in 2003, the market had already rebounded 23%. While tragic, the coronavirus mortality rate could also be considered as benign, at least up to now.
While no sector is really immune to the virus, those feeling the most pain are Energy and Materials (which are sensitive to global growth) as well as Consumer Discretionary (particularly luxury goods and tourism). Chinese consumers are critical for the luxury sector – according to Bain & Co, the luxury market grew 5% in 2018 to €1.3tn, and they accounted for 90% of that growth. We remain sector neutral with a preference for growth and quality.
Investors have exhibited the typical Pavlovian reaction to crisis scenarios, rushing to safe assets while expecting central banks to accommodate for any downfall on the macro front.
For Government bonds, the risk is that investors are too pessimistic – the market is now pricing two Fed rate cuts this year, while the Fed deems its policy to be appropriate. This could create an upswing in rates if the impact that coronavirus has on growth is less than feared. Therefore, for the layer of govies we hold in order to balance equity risk, we prefer to play the belly of the curve, keeping duration below benchmark.
We remain overweight on investment grade bonds, especially in Europe, where the ECB is playing an outsized role in supporting the market. Up until now, the risk-off mood has not affected European spreads. In contrast, in the high-yield space, spreads have widened, but not by enough to compel us to increase our allocation. In the Emerging world, we have a sprinkling of hard currency bonds which are performing quite well due to lower rates in the US. We prefer to remain in the hard currency space for now – emerging currencies are vulnerable to a news flow that is dashing reflation hopes and catalyzing flows to the US dollar as a safe haven.
Overall, we still believe that equity markets have fuel left in the tank for the bull run to continue through 2020. However, we remain neutral on risk for the time being, especially while the extent of the coronavirus remains an unknown. On top of this, stripping the epidemic from the equation, the same gap noted last month between elevated asset prices and economic conditions persists, meaning it is not unreasonable to expect some kind of adjustment. The consolation is that coronavirus just gives central banks one more reason to stay locked in an accommodative mode, which should prolong the Goldilocks scenario for just a little longer.
Author: Group Investment Office