Fear of a pandemic buffeted global equities hard this week, negatively hitting the MSCI World Index and plunging several market indices, including the S&P 500, into correction territory. Long-term Treasury bonds hit record low yield levels and gold rallied sharply as investors turned to safe-haven assets. While it is difficult to know whether these trends will continue, we do expect the markets to be choppy over the next several weeks.
Rising Downside Risks Spook Markets
Few things can negatively impact market sentiment more intensely than rapidly rising uncertainty. While China seems to be getting a handle on disease containment, with the rate of increase of new infections slowing, the transmission of Coronavirus disease (COVID-19) is adding uncertainty across the globe. More authorities have implemented or are considering containment measures that restrict economic activity. Consumer sentiment and behavior are likely to be damaged as a result. This means investors need to consider scenarios where business activity slows in more locations and companies experience more lost revenue than initially projected.
More worrisome, however, are people who have not traveled to China or been in contact with someone who has and have contracted the virus. Since health professionals do not fully understand how the virus is transmitted, surprise outbreaks may occur anywhere across the globe. Also unclear is how viable the virus will be in warmer weather. More uncertainty has come to the market and the range of potential downside outcomes has widened.
Market Participants Work With Probabilities
Opinions are difficult to develop when so little is understood about the virus. Our view coming into 2020 was that global growth would pick up modestly versus 2019. The outbreak of the virus means that, at best, economic data will remain distorted through the first quarter and at worst, risks to the downside will have risen sharply. Of greatest concern is that we really cannot predict the timeframe or full impact.
Analyses of past viral outbreaks provide some clues on potential outcomes, but we caution relying on this approach. China’s economy has changed significantly since 2003, both in its size, mix of services/manufacturing and role in the global economy. China accounts for 17% of global GDP today versus 4% at the time of the SARS outbreak. Within China, according to World Bank data, services’ share of GDP is now ten percentage points higher than in 2003. From an economic standpoint, the past may not be a helpful prologue.
Consequently, we expect the market to react to the news cycle, focusing on expert opinions and facts as the situation unfolds. This applies to good news as well as bad news. For example, if the outbreak in Europe is smaller than currently feared because of its advanced health care system, the probabilities of severe scenarios decline. In this scenario, investors would likely have a good appetite for risk assets. Recall that the S&P 500 was at a record high barely two weeks ago until sour sentiment knocked it down. Sentiment could snap back just as quickly as it fell.
Watch the Consumer and the Fed
The US consumer had very positive momentum prior to the outbreaks in China and Europe. The January employment report coupled with respectably solid consumer confidence should provide enough momentum to support spending and economic growth if the outbreak in the United States is muted. However, a pullback in consumer spending, driven by fears of travel or gathering in public places, could create a transitory reduction in GDP. Of greater concern would be anything that damages the overall employment picture. Over the coming months we will be watching several early warning indicators very closely, including:
The odds of the Fed easing this year have sharply escalated – Fed funds futures are fully pricing-in a cut by April. However, incoming data through the first quarter have, by and large, been better than expected. Based on reported data, there would be no reason for the Fed to act. The trouble is that none of these releases captured the rapidly growing risks caused by the COVID-19 outbreak.
Recent Fed speak has offered some hints of a change in position. Richard Clarida, vice chair of the Fed, has spoken of a “meeting by meeting” approach. While the Fed may typically like to wait to see the risks translated into data, there seems to be little benefit in waiting. Given the acute downside risk to the outlook, the Fed will likely err on the side of caution, with a March meeting rate cut now in the offing.
For Prudent Investors – Tactical Hedges and Liquidity
The high degree of uncertainty leads us to take a measured approach. Within our long-term portfolios, we have selectively reduced position sizes in consumer discretionary, cyclical and energy-oriented holdings, and at the margin increased position sizes in consumer staples and utilities. Sentiment driven sell-offs tend to lead to indiscriminate selling, which generally creates buying opportunities. For this reason, we have slightly increased our holdings in cash.
Within fixed income, we are also adopting a conservative approach. Both credit and high yield spreads have backed up from recent levels. While this has created modestly more attractive valuations, we are not changing our positioning at this time. Within currency markets, we have not observed any meaningful moves, in contrast to other areas. We suspect that given the global nature of the epidemic, the shocks have not amplified cross-country divergences. To date, we have not adjusted our currency positioning.
Within our multi-asset and regime-aware portfolios, we have reduced positions in riskier assets such as equities and shifted into traditional havens such as gold and long-dated Treasuries.
We continue to monitor this very fluid situation. In the short term, risk is likely to remain elevated across asset classes. But the longer the outbreak persists, the higher the economic costs. The silver lining is that once the virus abates, economic activity could resume quickly. In the meantime, supportive policy response could cushion the impact.
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