05 Mar 2020
Whilst the headline news on markets is clearly negative, for longer-term investors looking for a potential entry point, the key to markets may be less pessimistic news, as the delta of change typically drives market direction. This won’t be related to deaths, which are a lagging indicator, but to when new cases peak. The best estimate is that the spike is still at least a couple of weeks away. However, both in China and Hong Kong, there is reasonable evidence to suggest that containment measures are working and that the situation has an element of control. There have been only two deaths in Hong Kong and none in Singapore. In contrast, the mortality rate has been much higher for those infected in Iran, due to a less developed healthcare system. In China, outside of Hubei and Wuhan, it appears that the number of new cases is falling.
Anecdotal evidence from some emerging market managers is that firms are getting back to work, and a statement from Foxconn on Tuesday 3rd March saw the world’s largest contract electronics manufacturer and key Apple supplier stating that it expects its China-based production capacity to return to normal seasonal levels by the end of this month. Whilst there are still labour shortages, workers are now flat out working seven days a week, to make up for lost production. The company also indicated that it expects the production disruption to delay rather than entirely derail operations and that it had not seen the large-scale component shortages that had been rumoured in the industry. However, prices have risen for packaging materials as the raw products are being diverted and used for surgical masks. Chairman Liu Young-Way stated that, judging from the current state of work, the second quarter could meet expectations of a typical first quarter.
Whilst the Fed unexpectedly cut interest rates yesterday, an important factor to consider is that, compared to the Global Financial Crisis, the transmission mechanism for economic weakness at this time is the real economy to financial markets, rather than the other way around. This means that the efficiency of monetary policy to stimulate demand is likely to be lower. Fiscal stimulus at a time of a demand shock to the global economy would be the most effective response.
Another subject of debate is the impact of systematic trading on market falls. Work by strategists at Morgan Stanley and other leading investment banks suggests that daily flows are now dominated by shorter-term traders and that there is a big shift, compared to a decade ago, in the factors behind the movement of share prices in the short-term. The market structure has changed substantially in the last decade. In fact, 4 of the 75 fastest market corrections in history, measured as the fall from a peak, have occurred since 2015.
A danger for investors is that they get caught up in market noise and sentiment. Focusing on the three pillars of the asset allocation process; fundamentals, valuation and sentiment, reduces the likelihood of getting distracted by emotion. This strategy doesn’t aim to catch the market low point but intends to highlight when investors are likely to be on the right side of probabilities. While markets have sold off and equities relative to interest rates look potentially attractive, valuations are not, for the moment, excessively cheap.
Less pessimistic news could be the catalyst for a market rally, but this is unlikely to be in the short-term. Investors will be looking at various factors, including the intensity of cases. The first of these is how effective containment measures are. The northern hemisphere will soon be moving out of its peak flu season with better weather and more sunlight, resulting in higher levels of Vitamin D and potentially helping to improve immune systems. It is also possible that progress will be made in the production of a vaccine, which may be a year away, but would give markets a belief that an end is in sight to the disruption caused by the Coronavirus and drugs may be developed that could help alleviate the worst of the disease.
On the technical side, systematic trading is clearly an influence and risk parity funds will often reduce equity exposure when implied market volatility spikes, as is the case now. The best short-term entry points will be when markets are deeply oversold, which was the case on Friday 28th February when the market fell by 1,000 points.
At this stage, it is difficult and dangerous to estimate how substantial the downturn will be. A risk for markets is that there is a loss of confidence in Western economies and businesses and consumers cut back on spending so dramatically that an unnecessary recession occurs. London is undoubtedly a lot quieter than normal with hotel occupancy rates falling below 50% and an absence of tourists on the streets. At present, anecdotal evidence suggests that a lot of fundamental investors are waiting on the side lines to see how extensive the downturn will be, before committing to equities.
If investors see rolling downturns and recoveries, meaning that countries affected early emerge quickly from the problems, a case point being China, it may be encouraging for equities. Some sectors will be affected more than others, which could be challenging to Western, banks due to lower for longer interest rates. The moves in bond markets are more supportive of growth equities rather than value. The US$ has not been strong in this crisis period which is a positive for emerging markets as it allows rate cuts and monetary easing in the affected countries. Oil has rallied about 10% from its low point on hopes of production cuts at the forthcoming OPEC meeting, where there is a recommendation to cut output by 1 billion barrels a day, but whether this will be affected in practice remains to be seen.
Democratic primaries may also play a part. A potential concern was the nomination of a left-wing presidential candidate for the Democrats. Markets might be reassured if it appears likely that Biden will secure the Democratic nomination and Bloomberg’s recent withdrawal from the race can only make this outcome more probable.
Graham O’Neill, Senior Investment Consultant, RSMR
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