By Geoff Wilson
The coronavirus (COVID-19) represents the first test of the global market in 2020 and the event that will probably bring this mature bull market to an end.
In the last week of February, global equity markets experienced major routs shortly after reaching record highs. While the duration and severity of the virus remain unknown, the abrupt decline investors have witnessed is the beginning of the transition in stages from “emergence” to “lockdown”, which brings with it an overwhelming dose of fear.
As the effects of the disease filter from the directly affected (such as travel and discretionary-exposed companies) through to global supply chains, the economic dislocation will be significant. Although the final stage, “normalisation”, is inevitable, investors are experiencing a sharp adjustment to the recent euphoria as asset prices have fallen and volatility has returned.
‘Risk off’ contagion reaches equities
As a predictor of economic activity, the global equity market has been slower than other markets to adjust to the revised expectations for growth.
Risk currencies, such as the Australian dollar, buckled against the US dollar “safehouse” shortly after the virus emerged. Similarly, commodity prices have been falling and bond markets have demonstrated recessionary characteristics.
Price-to-earnings ratios remain elevated against long-term trends, despite the S&P 500 index entering a technical correction in the fastest retracement from recent highs in history. Equity markets finally adjusted to the reality that COVID-19 being viewed as a China problem is shifting to a global pandemic in the making.
More stimulus but with less effect
Governments and central banks have positioned for intervention. Two levers available to China are easier credit and fixed asset investment. We expect both levers to be pulled hard if the virus is not contained in the next few weeks.
On February 19, stocks rose after China first announced fiscal measures to support local businesses that are struggling due to the virus outbreak. Further economic stimulus from China, Hong Kong and Singapore as well as other central banks will occur in response to the market slowdown, and we can expect further cuts to official interest rates.
Expectations of an interest rate cut by the US Federal Reserve are near universal, with the 10-year and 30-year US Treasury yields falling to historic lows, and the Reserve Bank of Australia having cut the domestic cash rate at its March meeting.
In the low interest rate environment, further monetary stimulus is less effective and places the global economy under greater risk of further shocks.
To invigorate the global economy, the anticipated central bank efforts to stimulate will need to coincide with positive news about containment.
If this is not reached by April, we could see a bear market for the first time in 11 years.
If major stimulus and progress on containment occur, commodities and risk currencies will rally, likely beating equities to a recovery. Bonds, foreign exchange and commodities markets will turn quickly if the virus is contained as they have traded most aggressively after the outbreak. In particular, we expect copper price and risk currency strength will precede a recovery in equities.
Buy the dip or hold cash?
The question investors must grapple with is whether the opportunity to deploy capital is now or on the horizon. To adopt a positive view on the direction of equity markets, we need to see a slowdown in the growth of infections globally, progress from quarantine to mitigation, the resumption of supply chains and a monetary and fiscal push from governments and central banks.
It may be beneficial to wait for the disastrous economic data to flow through and test the reaction of equity markets, holding slightly higher than normal cash weightings while closely following market signals for a change in direction.
Normalising COVID-19
Looking outside markets, and listening to scientists, it is clear that COVID-19 is here to stay – a more deadly illness to join the common cold and influenza each winter.
The financial and economic impacts will weigh on markets as we progress from emergence to lockdown, but we will eventually reach a state of normalisation.
While the transition will provide opportunities and challenges, long-term investors in the equity market are generally well rewarded for their patience over time.