By Kevin Miskin, Hottinger Investment Management
In last week’s blog, we noted that the global economy could enter recession within the next 12 months and urged caution as the risks to financial markets were weighted to the downside. At the time, however, we believed that markets would remain relatively benign until closer to Easter. If, as Harold Wilson famously once said, “a week is a long time in politics” then it can seem an absolute eternity in investment markets.
During the first three weeks of February, the S&P 500 climbed to an all-time high and European stock markets reached levels not seen since the financial crisis as the broad consensus held that the global economy would avoid recession in 2020. Headline PMIs had troughed in October and PMI new orders were improving. US and European company earnings for Q4 2019 had exceeded expectations and high single-digit earnings growth was forecast for this year. There was a further assumption that as long as the coronavirus could be contained within China, the impact on global economic growth would not be too severe. However, with news of the virus spreading around the globe (notably in Japan, South Korea and Italy) towards the end of the month, this base case scenario was shattered.
The market reaction was both swift and severe as global equity indices fell into correction territory (a downward move of 10 per cent) in the shortest time period ever. For February as a whole, the MSCI World Equity index fell by 6.7%. The UK led the declines with the FTSE100 falling by 9.7%. Elsewhere, the major US, European and Japanese stock markets fell between 8% and 9%. Ironically, China became a port in a storm, with the Shanghai Composite index appreciating by almost 5% after markets returned from the Chinese New Year.
In the early stages of the coronavirus outbreak, Asian equity markets and cyclical sectors, such as transport, understandably bore the brunt of the selling. However, more recently it has been the ‘winners’ of last year that have come under pressure, including US Equities, technology, growth and quality.
The increasing chances of Bernie Sanders becoming the Democratic presidential candidate has also cast a pall over certain US sectors. His radical agenda includes breaking up banks by reinstating the Glass-Steagall Act, imposing a financial transaction tax, capping interest rates on consumer loans, increasing taxes for the super-rich and cancelling student debt.
In commodity markets, Brent Crude suffered a decline of 16.5% to $50, having traded at $70 in early January. Oil consumption in China has fallen by a quarter since the outbreak of the virus. Saudi Arabia is attempting to stem the price leakage by calling for a concerted cut in production of 1 million barrels per day, of which it has offered to bear the lion’s share. However, at the time of writing, Russia appears reluctant to fall in line. Gold initially fulfilled its role as a safe haven, rising to a 7-year high of $1,688, but ultimately gave up its gains to end the month in marginally negative territory.
The ultimate safe haven asset proved to be long-dated government bonds. Over the past two decades, the negative correlation between equities and bonds has hardly changed, despite ever-lower yields. The reason is that it is not the level of yield that provides the hedge, but the sensitivity to the change in yield, which comes from the length of duration. Therefore, even with today’s low/negative bond yields, having some duration in portfolios mitigated some of the losses from the equity market correction. The yield on the US 10-year Treasury closed the month at a record low of 1.15%, down from 1.51% at the end of January, representing a capital return of 3.3%. The UK 10-year gilt fell by 8 basis points to 0.44% and the German benchmark bund yield fell further into negative territory, ending the month at –0.61%.
At the short-end of the curve, the US 2-year Treasury yield has fallen below 1%, implying that the US Federal Reserve is expected to cut interest rates by 75 basis points by the end of the year. Meanwhile, the 30-year US Treasury has fallen to a record low of 1.7%, which suggests investors have become concerned about the sustainability of any longer-term recovery.
At the time of writing, the spread of the virus is accelerating outside of China and analysts are in the process of downgrading their predictions for global growth and company earnings. A Bloomberg poll of analysts has global growth predicted to fall to 2.8% this year, which would be the lowest rate since the financial crisis.
According to Absolute Strategy Research (ASR), we are at a crucial stage in the coronavirus narrative. During previous episodes when bond yields and equity markets have fallen to this extent, the relative valuation between the two asset classes has seen investors move back into equities. However, should risk assets fail to rebound during early March, ASR cautions that investors may start to focus on the potential for further supply chain disruptions with negative implications for global markets.
The disruption to global economic activity for Q1 may have now largely been discounted by markets. The question is whether the virus outbreak will be contained by the end of March or whether it will expand in terms of duration and geographic reach.
On the positive side, the slowdown in growth could yet prove to be short-term. In addition, recent political shifts towards anti-globalisation could ultimately prove to be beneficial; in Europe, companies have been stockpiling ahead of Brexit, while in the US companies have been forced to overhaul their supply chains as a result of the trade war with China. There is also hope that the spread of the virus could be curtailed as the weather turns warmer.
We believe a more likely scenario is that the disruption will continue into Q2 and result in a tightening in financial conditions. Central banks will likely respond with even easier monetary policy and governments may open the fiscal taps, which could provide short-term support for risk assets.
We were relatively cautious entering February and reduced equity allocations where appropriate as the virus spread beyond China. In the current environment, we will monitor developments while coronavirus fears continue to obscure the outlook for global markets until such a time as there is more clarity.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
Our quarterly report presents our views on the world economic outlook and equity, fixed income and foreign exchange markets. Please click the link to download.
