Coronavirus triggers dramatic market sell-off, now what?
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In the weeks since cases of COVID-19 first began to rise sharply, the economic consequences are coming into greater focus. There is still much uncertainty about how events will unfold, especially around the breadth and depth of virus outbreaks outside of China. Still, at this point we expect a slowing in global economic activity that extends through the second quarter. Supply disruptions suggest that the recovery in activity once the virus is contained will be gradual and fitful, rather than the rapid rebound in activity that many had expected.
We believe that the Chinese economy will likely contract in the first quarter. Note that even during the financial crisis, China did not register a single quarter of negative growth. Why might this time be different? Quite simply, the Chinese economy has undergone what can best be described as a sudden stop in activity as a result of work and travel stoppages in many parts of the country. Even regions not directly affected by these measures have still been impacted via supply chain linkages to regions that experienced shutdowns.
Chinese authorities have responded to COVID-19 with a range of economic support measures. Many of these measures have focused on ensuring financing availability or relieving immediate cash flow pressures for the private sector. Still, it remains unclear whether the senior leadership will still seek to achieve its six percent growth objective for this year. There is yet to be a formal and definitive communication on this, but the hit to economic activity looks to be large enough that trying to achieve the growth objective no longer looks practical.
As for the U.S., the combined impact of the coronavirus and the Boeing production halt suggests first quarter growth of around one percent on an annualized basis. The channels for the impact of the virus’ spread within China and elsewhere are as follows, with many of these channels reinforcing one another:
- Sharp reduction in Chinese tourism and business travel to the U.S.
- Reduced goods exports, due primarily to weaker demand.
- Reduced corporate earnings on falling foreign demand can impact hiring and investment decisions.
- Uncertainty/confidence channels that impact business investment and hiring, and through this channel the consumer. Falling stock prices play a role in increasing uncertainty/reducing confidence in the business sector.
- Falling stock prices have a further impact on household spending by reducing wealth.
Thus far, the first two channels have been most immediately impactful on the U.S. economy, and are easier to dimension. The other three channels will have a greater influence on economic activity going forward. Of particular concern is the impact of these channels on the labor market. The consumer has been an extremely consistent and solid contributor to this expansion, powering the economy through the trade war last year as well as the manufacturing recession of 2015-16. Thus, we remain attuned to the very real possibility that depressed earnings on foreign activities and increasing uncertainty regarding the spread of the virus domestically, will lead to a pullback in hiring and household spending.
It is worth highlighting that the first three channels above concern the spread of the virus outside the U.S. Should the number of cases in the U.S. grow, the uncertainty and wealth effect channels will become larger. In addition, if there is continued evidence of the virus spreading directly within the U.S., an additional channel would become operative, namely, a shock to domestic demand and supply: on the supply side, reduced business activity as employees stay home and supply chains experience further disruptions; on the demand side, reduced spending as activity outside the home falls and hiring slows. In addition, hourly workers could see an immediate reduction in take-home pay and would adjust spending accordingly. With greater evidence of “community spread” of the virus, these aggregate supply and demand effects now look inevitable.
An additional consideration is that the U.S. economy faces this new headwind at a time when it is particularly vulnerable to a shock. The economy had only recently begun to emerge from a manufacturing recession. In addition, aggregate corporate earnings growth has been anemic, and profit margins have been under pressure. Meanwhile, total corporate leverage remains near an all-time high. While low interest rates have reduced the burden of carrying high leverage, it is unclear how highly leveraged corporations will adjust hiring and investment in the face of an increasingly likely revenue shock stemming from the coronavirus. All told, these types of imbalances in the U.S. economy could serve as amplifiers of the economic fallout of COVID-19.
As the coronavirus continues to infect the bull market, we asked our seasoned experts from several of our boutique investment firms to provide some perspective by sharing their insights on the market.
Global Fixed Income Team
When it comes to portfolio implications, the imbalances previously discussed have long informed our late-cycle view of the U.S. economy. As such, our portfolios have been oriented towards shorter spread duration, over-weighting non-cyclicals over cyclicals, and a preference for higher quality credit. Therefore, we believe our portfolios have been well-positioned for the current environment.
In addition, while credit spreads have widened notably in recent weeks, they remain well within the average range of the current expansion. As such, given the significant uncertainty over how this risk event will play out in the months and quarters ahead, we still do not believe there is sufficient compensation for risk relative to the macro backdrop to consider materially adjusting positions at this time. We will continue to monitor for any dislocations in the market that could present opportunities, particularly as the macroeconomic consequences of the virus become clearer.
MacKay Municipal Managers
In 2019, on the heels of record industry inflows, declining rates, and tighter spreads, the team opportunistically sold weaker structures across our platform amidst high demand, increased credit quality amidst tighter spreads, and we continue to maintain ample liquidity. As similar technicals continued in January 2020, magnified by the recent “risk-off” trade, our defensive posture (while remaining active) is intact and we believe we are well-positioned.
Active management remains paramount. In a landscape of historically tight spreads and lower yields, incremental alpha delivered through deep credit and spread analysis can distinguish managers relative to passive approaches. We believe security selection and bond structure drive performance, and that liquidity management is always a critical aspect of the municipal investment process—particularly in this recent cycle.
Our market is comprised of approximately 70% individual investors where emotion and behavioral finance coupled with the lack of liquidity can lead to opportunities to navigate while buying the dips.
In terms of credit surveillance, we are monitoring all sectors of the market with a close eye on those that may have greater impact related to coronavirus (i.e. transportation, ports, hotels generating excise taxes, etc.). Further on credit and consistent with our insights, strategic underweight exposure is likely to drive outperformance in the high-yield municipal market. Quality high-yield investments will be key as cracks appear.
The impact of the coronavirus will be felt by many companies in many sectors across the globe. Less demand by consumers, less investment by companies, disruptions in supply chains, with few companies likely being spared. Travel/transport companies and commodity producers are expected to be the hardest hit. Markets are pricing in Fed rate cuts, but lower rates will not resolve the demand shock.
Hence, some form of a stock market correction feels appropriate. Though the duration of the infection and of the negative impact are very difficult to assess. Again, if the crisis dies out with warmer spring weather, demand and supply chains can come back to life and things should normalize—though investors might fear the disease might come back next winter.
A major U.S. brokerage did a survey and estimated that 66% of U.S. companies might see sales down zero-2.5% in 1Q20 and 19% would see sales down 2.5-5%. Those figures might be outdated but give a rough idea of the 1Q20 impact. They also claim global GDP would have a negative impact of 0.5% in 2020 if the virus dies out in late March, and 0.75% if 2Q20 is also impacted. Again, these are rough estimates.
The equity correction touches most regions equally. Even the U.S. did not outperform this time. And, the Chinese markets are starting to show some signs of bottoming out. From a style perspective, both growth/quality and value have been hit—almost in equal terms. As for sectors, consumer discretionary and commodity sectors were hit very hard, while health care and biotechnology did perform slightly better than broad markets YTD. All in all, the sell-off was broad based, but the first signs of equity recovery favor the U.S. markets—while growth/quality seems to rebound the best at the time of report.
Our basic assumption is that the epidemic will slowly stop with warmer spring weather, and that most of the pressure on consumer and corporate consumption will go away, leading to an economic rebound.
The health care sector is somewhat less impacted than other sectors given that medical urgencies still need to be performed, but still one has to assume some doctor and hospital visits have been postponed, some procedures have been re scheduled, and as many people work from home, demand for life sciences tools and reagents from labs has been temporarily reduced, especially in China.
We see this as a buying opportunity and are ready to further deploy our cash. Valuations have become more supportive given the limited long-term impact of the epidemic on earnings—again assuming the infection rates will soon drop, and the virus does not aggressively come back next winter.
Epoch Investment Partners
The coronavirus is an incredibly fast-moving subject, and its implications on global markets are changing almost daily. We aren’t sure of the impact this will have on global supply chains and don’t know if this is something that will be behind us in a quarter or two or more long term. Our base case is for a V-shaped recovery from the second quarter. However, the key risk is new epidemics outside of the Hubei province, potentially leading to a global pandemic.
For now, here are our most recent updates:
1. China is implementing an aggressive fiscal and monetary policy response
- This increases our confidence of a V-shaped recovery from the second quarter.
- However, Chinese Q1 GDP growth is now likely to come in at something like — 6% (SAAR).
- This implies a significant supply and demand shock to a host of sectors and economies.
2. Economies at risk of recession
- Japan (very weak Q4), Italy and France (negative Q4, marginally positive Q1), Germany and UK (flat Q4).
- World output expanded by just 2.9% in 2019 — the slowest pace since the global financial crisis — and just 0.4 percentage points above the International Monetary Fund’s (IMF) 2.5% threshold for a global recession.
- Cyclical data will be extremely volatile and unreliable through at least May.
3. Policymakers are hyper-responsive to any growth risk
- This means more liquidity: Lower for even longer, and a continued world of yield starvation.
- Central Bank expectations: Within one year expect two more cuts by the Fed, two by the Bank of China, four by Mexico, and one by the Bank of England.
4. Potential impact the virus may have on global supply chains as it spreads
- Apple has been in the headlines and is being affected by both a supply and demand shock. On the demand side, Apple had $44 billion of sales in China last year, representing nearly 17% of its revenues. Given temporary store closures and such, it will be very difficult to top that number in 2020.
- A wide range of consumer-facing companies will face challenges from the 1Q20 demand shock. These companies include: hotels, airlines, payments, medical devices, cosmetics, luxury goods, athletic clothing, and beverage companies, as well as pizza and restaurants (although take-out and delivery are doing much better than dine-in).
- Overall, a very large proportion of large-cap companies are actively selling into China and other markets where the virus is spreading — such as: Japan, Korea, and Italy.
- At the beginning of the year we thought China would grow +6% in 1Q20. Now we expect it to contract by that amount. That is an enormous shift in a short period of time.
- In some cases, demand will snap back in 2Q20. For example, if a consumer had set money aside to buy a car or luxury handbag. But in many cases, like pizza or soft drinks, that demand will just evaporate and be gone for good.
- In addition to the demand shock, the supply side shock to global value chains is enormous. In fact, the globalization of production has been a key reason for why margins have improved so dramatically over the last two decades.
- However, globalization is in retreat, largely driven by the policies of Presidents Xi and Trump, and the coronavirus will further accelerate this damaging trend.
- There are hundreds, if not thousands, of companies that have China at the heart of their global value chains. This is particularly the case in sectors such as tech hardware, electronics, machinery, textiles, and consumer products like toys.
As a result of the points mentioned above, it is ever more important to favor companies with a demonstrated ability to produce free cash flow and allocate that cash flow wisely between return of capital options and reinvestment/ acquisition opportunities.
As a “passive” manager, it’s important to note that we don’t adjust our portfolios in anticipation of or response to market events. Rather, our “active” component is our discussions with clients on portfolio construction.
Given the recent volatility, we see this as a good time to highlight the importance of having an evergreen portfolio allocation to alternatives. As the swiftness of this market drawdown illustrates, waiting for turbulent times to add alternatives to a portfolio does not work. This is a message that we have been telling for the last ten years but has been generally ignored by the markets as sell-offs in equity markets have often been met with accommodative monetary policy (or at least the expectation of such) that sets a floor on equity prices and effectively neuters the impact of alternatives.
We don’t pretend to have a crystal ball and can’t predict the next market move. We will say that the recent market response was probably a little late as Apple’s earnings announcement at the beginning of the week of February 17th probably should have been the “canary in the coal mine” that the coronavirus was going to have a material impact on operations. However, it took the markets a day or two to finally say…“Wait, what?”
Although we do not have a crystal ball, we do think it’s prudent to expect continued volatility and would caution investors to be prepared for further declines.
Winslow Capital Management
We entered the year with expectations of a subpar recovery in global growth.
Sequential 1Q20 growth in China has been projected as low as zero —which could have been lower, but we wouldn’t expect the Chinese government to report data if growth was in negative territory. The quarantine is the real story in China, when it comes to economic impact, since people aren’t going to work. However, we expect China to return to “functioning normally” sometime in 2Q20.
In the U.S., the Fed is still grappling with how big the impact will be to the U.S. economy. The Dow Jones is in correction territory, and the selloff has been entirely driven by valuation multiples (i.e. we haven’t seen meaningful earnings cuts yet). The market is now pricing 2020 in as flat to low single digit earnings-per-share growth year rather than the previous 10% consensus forecast.
Therefore, we believe we could see a back half loaded year if economic activity stalls in 1Q20 and 2Q20. So far, most companies have mentioned the virus, but haven’t lowered their numbers yet. Most cuts thus far have been in consumer discretionary (travel/hotels/leisure), and we expect more cuts in Technology and Industrials. We haven’t necessarily seen dramatic cuts to earnings yet, so for now this feels more like “fear” than “reality” — and panic selling has never paid off.
Multi-Asset Solutions Team
Many market participants have discussed the prospect of a V-shaped recovery – a short-term decline in economic growth followed by a rapid recovery. However, we find this hard to believe. At best, investors should expect a U-shaped recovery to global growth – a stagnation before any eventual recovery – if not an even more prolonged impact.
Perhaps adding to the negative impacts, many economic indicators investors traditionally rely on for an accurate read on economic growth will be meaningfully obscured. The current data coming out of China is not encouraging. Economic activity in China has begun to halt – the longer it takes for activity to normalize, the more impact to supply and demand.
As ever, no one knows how the virus and its economic and market impacts will unfold from here. Factoring in the recent market pull back, equities look expensive and vulnerable to policy mistakes and shifts in sentiment. For evidence to that effect, we continue to monitor:
- COVID-19’s impact numbers and geographic spread.
- Alternative proxies for economic activity.
- The impending responses from governments and central banks.
Normally, a 10% decline in the market offers a solid buying opportunity for investors. However, the hit to growth is likely significant, and the situation has the potential to worsen. We have been defensively positioned and will maintain that position until more clarity is reached. “Buy the dip” is dead—at least for today.
If these trends solidify and extend to new regions, risk assets will continue to be negatively impacted. Emerging markets equity, highly cyclical and most acutely impacted by the virus, would be hardest hit. U.S. bond yields have already experienced meaningful declines, reflecting a global flight to safety. Currency volatility – with the U.S. dollar strengthening asymmetrically against emerging markets and particularly Asian currencies – will persist.
A Note on Investor Behavior
During times of volatility investors tend to run for the hills. Staying invested is often the best option for overcoming short-term market stress. If you’re confident in your strategy, maintain your position or even add to it as the market moves lower. Alternatively, if you need capital or decide to shift your allocations significantly in a volatile market, be aware of how market conditions will affect your trade.
Global Risk Trends & AnalysisView the latest market insights from our multi-boutique investment firms
Alpha is the excess return an investment has provided above and beyond a market index or benchmark that represents the market’s broader movements. A V-shaped recovery is a short-term decline in economic growth followed by a rapid recovery. Active investing is an investment strategy involving ongoing buying and selling actions by the investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions. Active management typically charges higher fees. Passive investing is an investment strategy that aims to maximize returns over the long run by keeping buying and selling to a minimum. The idea is to avoid fees and the drag on performance that frequent trading can potentially cause. Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
The views expressed herein are from MacKay Shields, Candriam, IndexIQ, Epoch Investment Partners, Winslow Capital Management, and the Multi-Asset Solutions Team, and do not necessarily reflect the views of New York Life Investment Management LLC or its affiliates. New York Life Investments engages the services of affiliated, federally registered investment advisors such as MacKay Shields LLC, Candriam, and IndexIQ, and unaffiliated, federally registered investment advisors, such as Epoch Investment Partners, Inc. and Winslow Capital Management, LLC. The products and services of New York Life Investments’ boutiques are not available to all clients and in all jurisdictions or regions.
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