The last week has been exceptional, both in terms of market movements (see chart below) and how quickly the outlook for the global economy has evolved. Last Monday, we outlined our view that it seemed likely that containment of the novel coronavirus within China had failed. Data released since then has supported that view, with large outbreaks in Iran, South Korea and Europe.
Changes to the way markets operate can be given some blame for the speed of the equity market correction. Prior to the GFC, global investment banks helped partly absorb market shocks by providing liquidity (buying equities and bonds). Changes to regulation post the Crisis has made banks safer but mean they can no longer provide this role. In addition, the rise of leveraged systematic investment strategies (which are forced to sell equities when they are falling) is likely exacerbating market corrections.
That said, there is a strong foundation for negative market sentiment. We are in the midst of a pandemic, which seems to be quite severe, particularly for those over 60. The likely initial response to this pandemic is some form of forced or voluntary social isolation until the threat eases. By this we mean large gatherings are cancelled, schools are closed, public transport is shut down or avoided, people work from home if they can, restaurants and shops are empty. We have some precedent for this – China had largely shut itself down from mid-January and only now is economic activity slowly beginning to recover (the impact on growth in the region has been enormous, see chart below).
The alternative to social isolation is letting the virus spread unhindered through the population. In this scenario, a large portion of the population is likely to miss work for extended periods of time due to personal illness or caring for loved ones. Hospital systems could become overloaded, increasing the mortality rate of the disease. If there is a choice between a sharper economic contraction with a quicker rebound but more fatalities or a shallower, but longer economic correction with fewer fatalities, our assumption is Governments will continue to favour the latter. Either way, we expect economic data to be released in coming months will be extremely weak.
Extrapolation of recent Asian economic data into the rest of the world almost certainly implies a decline in global economic activity in coming months. In scenario analysis conducted by Goldman Sachs, the impact of the virus on the US consumer, assuming near total cancellation of large gatherings (80% less spending) and a moderate pullback in less social, but still discretionary, “at risk”, consumption (10% less spending) would see a 1.6% reduction in the level of US GDP over the period it continued (see below). This effect is in addition to the drag on growth due to supply chain disruptions (expected to reduce growth by a further 0.65% on average this quarter and the next). This analysis also assumes no second-round effects from the growth slowdown, such as increased unemployment.
Governments and central banks will try and offset the economic weakness via stimulus measures. Markets are already pricing more rate cuts across the world. However, lower interest rates don’t really help if people can’t leave the house. Governments could be more helpful by easing cash flow constraints on households.
Applying this additional growth slowdown (assuming a cumulative 3 months of disrupted activity in the next two quarters) to our earnings models would see global EPS fall by around 5%. We would also expect continued multiple compression in this fearful environment. Typically, in a recession the US forward PE falls between 20% and 60%. So far, the multiple has fallen around 10% in the US, pricing in little risk of a further growth slowdown.
While we still think there should be a strong recovery in the second half of the year, markets are unlikely to price in this rebound until we have more certainty around the impact of the virus, both in terms of its severity and its economic impact. A more immediate recovery in markets could be sparked by progress on a treatment for the virus (a drug called Remdesivir is in clinical trials) or a meaningful downward revision in current estimates of the transmissibility and severity of the virus.
Equity markets rallied very strongly on Monday night in response to central bank stimulus hopes. Chinese authorities announced additional stimulus measures on the weekend, including loan repayment holidays for affected businesses. Governor Kuroda said the Bank of Japan would "strive to provide ample liquidity and ensure stability in financial markets." G7 Finance Ministers and Central Bank Governors plan to hold a conference call Tuesday (US time) to discuss a response to the outbreak. We think this presents a good opportunity to reduce equity risk in the portfolios and position for our central case view of continued equity market weakness. As a result, following our reduction in equity exposure last week, today we reduced further, to below neutral.
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