When markets panic, the only investment mantra I believe in is “breathe, think, act”. Sell-offs can provide fantastic buying opportunities, but elevated risks often accompany them. After last week’s sharp drop in global equities, is this now a good entry point or is this a falling knife we do not want to catch? Are markets overly worried about coronavirus or are more negative prospects not yet priced in? We believe that, at these levels, risk assets offer attractive long-term expected returns, but more volatility is likely to come.
Are markets overly worried about coronavirus or are more negative prospects not yet priced in?
As of today, almost two months after the first reported cases of coronavirus, there have been around 89,000 confirmed infections and 3,044 deaths worldwide. People are understandably worried but, bearing in mind that most infected people (those with mild symptoms, which accounts for around ~80% of estimated cases) are not accounted for in these numbers, the “effective fatality rate” appears to be a much smaller ~0.7%.
As fears of a global pandemic mounted, global equities experienced their worst week since the global financial crisis and the fastest correction in history, with US and European equities falling - 11.5% and -12.3% respectively, dragging down high-risk credits too, with Euro and US high yield spreads widening by +91bps and +109bps. With markets tanking and investors seeking optionality and insurance, the CBOE Volatility Index (so called “Wall St Fear gauge” or simply VIX) rose from ~17 to ~40 over the week. Interestingly, typical defensive assets delivered downside protection at different times: the gold price touched an intra-day peak of +2.8% on Monday but lost 6% from then until the end of the week; the Japanese Yen rose steadily and closed the week with a gain of +4% against the US dollar; US 10 year Treasury yields, after being almost flat on Monday, narrowed by ~33bps over the following four days to all-time lows (with the market currently pricing in two cuts by the April Federal Reserve meeting).
Real economies are suffering too. In an effort to reduce contagion, many countries have been restricting travel, cancelling large public events, suspending public transportation and quarantining people. As previously discussed, the predictable effects of such measures have been a short- term decline in economic activity with a deterioration in consumption, growth and investor sentiment. Looking forward, we believe there are two scenarios likely to take place. In the more negative scenario, infections increase in western countries and economies hit the brakes further to prevent contagion. Here, a synchronised global slowdown taking place in an already weak, mature business cycle could increase recessionary fears and spark a further sell-off. In a more positive scenario, western economies take advantage of the lead time and cope better with the outbreak with minimal economic disruption. Also, as China restarts its operations and global governments and central banks plan for fiscal and monetary stimulus, economies recover faster than expected and oversold financial markets reprice as a consequence. There is elevated uncertainty out there and it is not easy to evaluate which outcome will play out, nor what is priced into current market valuations, but we are currently leaning towards the latter scenario.
We came into last week’s rout with lower equity allocations than in most of the last five years in recognition of elevated valuations and risks. This allowed us to add some risk back on Friday (when we meaningfully rebalanced our equity allocations, which had fallen below their targets) and to still have some headroom to take a constructive view going forwards, which we are thinking of implementing via options. In such a volatile environment, a diversified portfolio is the most efficient way to achieve your long-term investment outcomes. Breathe, think and act without letting panic take the lead.
1 Sources: Bloomberg, Chinese Center for Disease Control and Prevention
2 “Unknown unknowns: the coronavirus”, Michael Clough, Global Matters Weekly, 03 February 2020