An economic shock, but we caution against overreaction
The outbreak of the coronavirus (COVID-19) is a human tragedy for all those affected, and recent heightened concerns are spilling over into global economic and capital market concerns – causing sharp drops in market values and an increase in volatility.
Capital market investors are facing the difficult task of incorporating a worrisome event, that is evolving by the hour, into market prices. Whenever that happens, especially where fear and uncertainty are involved, market responses are a swirl of both emotions and a reassessment of fundamentals.
After weeks of knowing about the coronavirus, hearing about government quarantines and travel restrictions, you might be wondering why are markets reacting now?
Capital markets will tolerate some economic disruption if it is viewed as temporary and largely transitory. The belief is that, outside of tourism, other consumption would be expected to see a post-crisis bounce to offset the lost output. Until recently, equities had been eager to adopt this view, looking past what is expected to be a valley for Q1 growth and earnings. As the virus has spread, that belief is being challenged and recent days have seen equities moving lower to price in some damage to the economic growth outlook. The problem is, it remains impossible to know the magnitude of the economic impact in advance. In the background, capital markets are being influenced by reassurances (and measures currently being adopted) from government fiscal and monetary authorities that they stand ready to respond with stimulus measures should that be deemed necessary. The bond market has been less sanguine and is responding to higher expectations for central bank easing.
What to expect? More volatility.
We expect that markets won’t stabilize until fear and the number of new cases has peaked. This does not mean that equities will remain in a free-fall throughout the period of crisis, simply that volatility will remain elevated. Once signs of improvement emerge a “relief rally” can ensue (here it’s important to note that improvement does not require any sort of “all-clear” declaration, just news of “less-bad” data). Here we expect the most beaten-down assets (in today’s markets, we see those as emerging market equities, airlines, oil, copper to name a few) to see a ‘relief’ rally.
The history of stock markets and health crises – a familiar pattern.
The world has faced 12 epidemics in the past 40 years and six Public Health Emergency of International Concern (PHEIC) declarations by the World Health Organization since the designation was adopted following the 2003 SARS epidemic. With each episode, markets experienced a relatively short-term risk-off reaction where equities fall and bonds and gold rise. After the peak of each episode, the market sell-off subsides, investors move from fear driving their investment decisions back to fundamentals driving asset gains, and equity markets typically recover six to twelve months later.
GLC’s capital market views
The backdrop: Views on the global economy.
It is impossible to know in advance the magnitude of the virus’ impact, but we do see it as a sizeable exogenous shock to both demand and supply. The extent of the economic damage not only depends on the degree to which the virus spreads but also the extent of government reactions through quarantines and restrictions on mobility and activity. There are also potential impacts on consumer and corporate behavior. Magnitudes are difficult to predict; outcomes being modelled range from a one-to-two quarter data distortion at best, and to a sizeable hit to the global economy through a multi-month decline in global consumption at worst — notably, it is consumption that has been the pillar of global growth. At this point however, we do not see a global economic recession on the horizon (see more within our GLC 2020 Outlook update below).
The view on equities
We see this equity market check-back as reasonable, and – from a market conditions perspective - healthy, especially given the stretched level of valuations and overbought conditions that exist(ed) in many equity markets. Going into this recent period of weakness, the risk of disappointment for equities was already very high. The S&P 500 had risen 17% from early October to Feb. 19 (the day of Apple’s negative guidance announcement and the near-term peak for equities) which is an annualized move of 51%!). The S&P 500 sat more than 11% above its 200-day moving average (dma) – the highest level in two years, and corrections back down to the 200 dma are common. The current correction (as at the close on Feb. 25) for the S&P500 is more than 7.6%. Keep in mind that corrections of 10% or more (peak to trough) are not an extraordinary or unusual move for stocks, especially given how hard stocks have run. Consider that the S&P 500 hasn’t witnessed a 10% pullback since the ‘near-bear’ market of late 2018.
The view on fixed-income
Bond markets, as expected, are benefiting from the risk-off trade and helping to stabilize the equity market volatility within portfolios. So, if you have a well-diversified portfolio with fixed-income investments that align with your investing time-horizon and/or risk tolerance…you’re likely feeling much better about things than headlines would suggest. GLC’s fixed income portfolios and balanced fund positions in fixed income are delivering an important positive performance offset to equity market weakness.
Bond yields have moved sharply lower - U.S. 10 and 30-year yields have hit record lows, while Canadian yields are holding in better. This reflects not only a flight to safety, but also a reaction to the dovish response from global central banks (seventeen central banks have cut interest rates in 2020, and those that haven’t have signalled a willingness to do so should they deem it necessary given the situation). With yield curves globally already relatively flat, it hasn’t taken much in the way of downward moves in yields for portions of the yield curve to invert, especially in the U.S. These moves are eliciting the calls of recession signals – something the media loves to highlight. We certainly pay attention to the yield curve, but we also consider the distorting impact of central bank actions and quantitative easing. We are not saying the yield curve has lost all utility in signaling economic conditions, but to ignore that we live in unprecedented times, especially when it comes to the bond market, is too naïve an approach. As active fixed income managers, we incorporate all relevant factors, and as a result, we don’t see an imminent recession in the near term (for more see our 2019 Insight on the inverted yield curve).
What GLC’s portfolio managers are doing?
The benefits of active management are most often realized during periods of market volatility. As an added value, this corresponds precisely with when investors, if left to their own devises, are most likely to make emotional decisions/mistakes that could derail their long-term investment plans.
At GLC, we adopted a slight defensive position in the fall of 2019, largely predicated on concerns over equity valuations. The coronavirus wasn’t on anyone’s radar until early 2020, but our slight defensive position does afford us the liberty to assess the unfolding events from a position of strength. In addition, the healthy reaction of the markets (penalizing the most over-valued of assets) has played into our thesis and may reveal buying opportunities for high quality holdings at more reasonable valuations. GLC’s portfolio managers are watching events closely and seeing this as an opportunity to add value and contribute to strong long-term investment performance.
All of GLC’s portfolio managers, including our Global Multi-Asset Strategy team (which oversees the balanced and asset allocation funds), are watching closely – not just for emerging risks, but with a longer-term perspective on emerging tactical opportunities.
Consider that we’ve seen notable price movements over the last three days that offer context to suggest that the COVID-19 situation is providing an opportunity to let some air out of the most overblown areas of the equity market. Specifically, U.S. equities that had run up the most, have fallen more than their developed market peers (including Canadian equities, which have held up better). Likewise, within the U.S. market, the information technology sector and the tech-heavy NASDAQ (the darlings of 2019 returns) are facing some of the strongest selling pressure.
How are our views evolving for GLC’s 2020 Capital Market Outlook?
GLC’s 2020 Outlook called for a mild global rebound, predicated on several catalysts that we labelled as “Green Shoots”. Our overall view on the full-year outlook is little changed. What has changed is timing of certain elements and the magnitude of some of our forecasts – most of which create more opportunities for our portfolio managers to deliver value through active management in light of the unfolding events. Importantly, we hold stronger convictions on some elements of our outlook and undoubtedly there are greater uncertainties regarding others.
A quick snapshot of our evolving views on each of our 2020 Outlook catalysts:
1. A détente in the trade war – more likely given global economic weakness and uncertainty and proximity of the U.S. election.
2. Return of business investment – less clear as businesses navigate the actual and expected impact on supply chains, and confidence in the growth outlook.
3. A bottoming in sentiment data – expect a near-term decline. By nature, sentiment data surveys opinions, as such they suffer from a two-pronged impact: reporting of an actual deterioration in conditions and responses based on emotional reactions, which can be fleeting and shift quickly.
4. Gradual inventory restocking – more likely and likely more positive when it happens. Shutdowns and supply chain disruptions should build more pent-up demand to be released when the crisis wanes.
5. Support from accommodative central banks – Much more likely and already happening. Both equities and bonds have responded to these signals, and there is risk that they’ve over-reacted.
6. Stabilization in the Chinese economy, aided by policy stimulus – Good news and bad news. The timing is pushed out for economic stabilization, while the timing and magnitude for policy stimulus has moved up. This may lead to some interesting timing as the lagged impact of the monetary and fiscal stimulus could coincide with the post-crisis recovery; thereby providing an extraordinary impulse to economic activity that could ignite exuberance over the outlook for China in late 2020 or early 2021, likely stirring excitement for risk assets and commodities.
7. More accommodative global fiscal policy – increased likelihood. This is especially the case for the Eurozone, where the hit to Chinese growth has a larger impact and the COVID-19 is currently spreading. Recent readings on the health of the Eurozone economy pre-COVID-19 were weak, especially in Germany. This leads us to believe in a much higher likelihood for fiscal stimulus to add to already aggressively easy monetary policy.
8. The global consumer continues to remain healthy – less clear. The magnitude and duration until a turning point comes will dictate the degree of impact on consumer behaviour. Suffice it to say that the longer and more expansive the COVID-19 epidemic, the less positive the signal.
What should investors do?
Market corrections are uncomfortable, but we caution investors against emotional reactions that take them away from their well-balanced and risk aligned investment plans. Likewise, GLC’s portfolio managers are not abandoning their well-thought-out investment strategies, and we don’t think investors should either. In fact, the value of an investment plan that keeps a long-term focus on your goals increases during times of market volatility with the ability to capitalize on market opportunities.
Copyright 2020 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).
This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.