28 Feb 2020

Reactions to the selloff

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Thumb: Reactions to the selloff
by Binay Chandgothia, CFA, Managing Director, Portfolio Manager and Head of Asia
Seema Shah, Chief Strategist
Robin J. Anderson, Ph.D., Senior Global Economist

Another day of gloom for risk assets

  • The selloff on February 27 capped the fastest equity market correction (10% drop) in the S&P 500's history. All it took was six trading sessions to take the index down from its peak 3,386 on February 19, 2020 to 2,979 on February 27, 2020. The speed of the decline over the past week even beats the Black Monday episode in October 1987, where the peak was in August 1987.
  • Technically, the markets have broken several short-term support levels. Selling by momentum-oriented strategies and risk-parity investors may have constituted a large portion of the selling that went on. There may also have been an element of capitulation by retail and fundamental long-only investors, lightening market positioning considerably in the last few sessions. However, buyers have been hard to find, with holders of buying power staying on the side-lines.
  • Coronavirus fears were primarily to be blamed for the loss, as U.S. authorities swung into action, with the state of California putting 8,400 residents on a monitoring list. The rising chance of Bernie Sanders winning the Democratic Party nomination process probably added to the market angst, given market fears that he would follow a 'tax-and-spend' policy.

How are global risk assets reacting?

Ex-U.S. markets were hit equally hard in recent weeks though they have outperformed the U.S. in the last few trading sessions. Most markets show a drop of 10–12% from their 52-week highs (as of February 27, 2020). A factor supporting ex-U.S. markets: cheaper valuations relative to the U.S. Based on our valuation composite, U.S. equities (MSCI US) were as expensive relative to global equities (MSCI AC World Index) as they have ever been at the end of January 2020.

Most markets show a drop of 10-12% from their 52-week high
Most markets show a drop of 10-12% from their 52-week high
Source: Bloomberg, Principal Global Investors. Data are as of February 27, 2020.

China, the epicentre of the crisis, has performed well in relative terms lately, helped by promise of monetary and fiscal easing as its government pledged to do enough to meet its economic targets. The Hang Seng index, the Shanghai Composite Index, and MSCI China (offshore Chinese equities) were all in positive territory for the month.

Unsurprisingly, other risk assets also sold off along with equities. Oil prices in particular have been very weak. High yield spreads have widened about 100bps this year based on ICE BofaML U.S. High Yield Index but aren't yet at alarming levels, as total yield for borrowers is still very low, given the sizeable drop in U.S. treasury yields. Anti-fragile assets (long-dated U.S. treasurys and gold) have been big beneficiaries of the sharp risk-off move.

Antifragile assets have been the big beneficiaries of the risk off move
YTD % change
Antifragile assets have been the big beneficiaries of the risk off move
Source: Bloomberg, Principal Global Investors. Data are as of February 27, 2020.

How is COVID-19 impacting global growth?

COVID-19 is set to introduce significant earnings hits to companies and guidance is deteriorating by the day. Despite a strong fourth quarter reporting season, 1H20 earnings revisions have been sharply lower since the outbreak, especially for commodities (energy/materials) and cyclicals (industrials and discretionary). Energy has experienced some of the largest revisions, driven by the collapse in oil.

While technology has held up relatively better on upbeat guidance from fourth quarter, supply chain disruptions, labor impairment, and factory/store closures will likely pressure earnings growth expectation in 1H20 and push out expected benefits into 2H20 and beyond. Microsoft, Apple, and HP all said they would miss guidance for the current quarter. Similar to the U.S.-China trade war, given ongoing COVID-19 spread and containment efforts, companies are still struggling to fully quantify the impact.

A recent Bank of America report spooked some investors, as it predicted that 2020 would be the weakest year for global growth since the financial crisis. Certainly, as we think about the growth outlook in the face of continued bad news, we must consider the impact of workers and children being forced to stay home. For example, in an environment with extended school closures, large businesses with strong balance sheets with capabilities for remote working may initially seem sturdy. However, small businesses and non-office-based workers who wouldn't be able to work when home with their children will likely be faced with lost wages and potentially lost jobs. This type of situation could drive some businesses into default—which, in turn, will transmit to broader financial problems and credit stress. Although hypothetical, this example illustrates how COVID-19 could ultimately be the impetus for recessionary pressures.

Not all is doomed! Here are some positives to look for:

  • Trade war: The U.S.-China trade war had forced many companies to prepare for prolonged supply disruptions, leaving them in a stronger state for the current challenge.
  • Infection rates: Daily infection rates have dropped in China and factories are running again, although they remain far below full potential. For the second largest economy in the world, recovery will be almost as beneficial as its decline was devastating.
  • Fed action: The large drop in equity markets will likely panic policymakers into action. News from Asia suggests a faster pace of rate cuts in recent days. The critical question: How soon does the U.S. Fed capitulate? Markets are pricing in about 80bps of cuts in the next year. While rates remain very low, the efficacy of more cuts on the real economy is debatable. However, from a market sentiment perspective, it would certainly help to see the Fed making a forceful statement to the markets that it remained committed to its growth objective.
  • Global fiscal policy: Fiscal policy will be a key driver going forward and there is evidence that policymakers are cognizant of this need. Governments appear to be stepping up to the plate, with even Germany temporarily suspending its debt limit and talking about potential stimulus measures. Hong Kong and Singapore announced large fiscal stimulus programs, and others are likely to follow suit.
  • Unchanged, long-term outlook: While the short-term outlook has deteriorated, the outlook for longer-term investors is broadly unchanged. Virus disruption is very unlikely to force the world economy into an extended recession (though perhaps a short one). So we believe that a large,
    but temporary hit to economic activity should be followed by a bounce back later in the year. And monetary and fiscal stimulus will likely drive that upside scenario much higher than previously assumed.
  • Valuations: At the start of the year, we found spreads and equity valuations tight. After the recent correction, both are better placed.
  • Prospects for a vaccine: Gilead Sciences' drug Remdesivir is the one drug WHO believes potentially has real efficacy against COVID-19. Though the company is just starting clinical trials (and it would likely be several weeks to months before the drug comes to market) it raises a glimmer of a hope. Novel viruses have a habit of appearing and disappearing as quickly.

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