The notable equity market correction that materialised since February 19 has dented the risk-on momentum which we have seen throughout most of 2019 and into 2020 pushing global equity indices to new highs just recently. And while ‘buying-the-dip’ type of strategy has worked very well since the great financial crisis, the ever-worsening coronavirus situation is opening up market expectations to a broader spectrum of possible economic outcomes.
This higher degree of uncertainty is challenging the market conditioning which has supported risk-taking in the past years. Secondly, the market-positioning, which has favoured growth stocks boosted by the movement in yields, has generated a weak asymmetry within risky assets increasing the scope of rotation risks in volatile markets. Thirdly, this is not the type of crisis that can be countered by further central bank stimulus.
As the hoped-for termination of the coronavirus remains out of sight, at least for now, we can focus on understanding the sources of uncertainty and identify the key elements to look out for that can indicate potential economic stabilisation and provide clarity on the path forward.
The first source of uncertainty is the economic and market conditions at the start of the virus outbreak. Global economic growth was low in 2019 with expectations of reacceleration in 2020, unemployment rates were falling and sentiment indicators were gradually improving. Central bank involvement remained high in most economic regions as inflation (as well as inflation expectations) was low. This environment has led to the decoupling in equity valuations versus fundamentals placing a high onus on future corporate earnings growth to better sustain the price momentum.
The second source of uncertainty is the path of the virus and the short-term economic impact – whether this will remain the case of regional health crises or can it develop into a potential global pandemic. How can the virus be contained and will the measures required to contain the virus result in a broader economic shock? The short -term economic impact and how quickly this can be reversed is still difficult to assess at this stage. Despite the stabilisation in the rate of new cases in China, various activity indicators show that the level of activity in China is still at around a quarter of the normal levels.
The third source of uncertainty is the longer-term economic impact. Will the current China paralysis permanently impact the country’s economic development process? To what extent will this affect the global economic dynamism? The long-term impact can also be in the form of material consequences on the path of de-globalisation mainly through shifts in global trade and further support for protectionist policies.
There are some key indicators to look out for at this stage to understand the proximity to stabilisation and which can give some clarity on the path to restore normality. Firstly, it is information from the medical field and the progress on understanding the virus and how to contain it. Secondly it is how quickly economic players will restore confidence and re-engage in business activities. As the level of risk aversion due to the fear of the unknown remains high, consumer and business sentiment will remain weak.
Third, it is the damage dealt to businesses, whether this event exposed previously unknown vulnerabilities and with which speed and to which extent can the damage be recovered. A number of companies have already lowered their profitability guidance citing disruptions in supply chains as the main factor impacting their outlook.
The recent downward movement in equity markets can provide a tempting opportunity to ‘buy the dip’. However, given the high expectations of stronger economic growth and improved profitability which sustained the expansion in equity valuations in the recent rally, a cautious approach is warranted at a time where the underlying market assumptions are being tested.
Focus should instead be placed on maintaining agility within investment portfolios through higher cash allocations and retaining companies with strong balance sheets that can absorb a potential deep economic shock and a business model that is less sensitive to supply disruptions and demand elasticity.
There will come a time where opportunities to pick up companies that have been unreasonably sold-off with the rest of the market will offer value at relatively cheap prices. Therefore a selective strategy is a preferred option in the current environment while passive instruments should be avoided.
Matthias Busuttil is head of Investment at Curmi and Partners