It’s hard to believe that just over a month ago global equities were trading at all-time highs. Following the spread of the coronavirus from China to the rest of the world, governments began to lock down their populations. Many sectors of the international economy are therefore suffering a huge drop in demand and global real GDP growth expectations have fallen precipitously, at least for the first half of 2020. This came as a shock to equity markets, which sold-off sharply. Recently, equities, as measured by the MSCI All Country World index, have rallied 16% over 3 days to 26 March from a low set in on 23 March. In the section below, we list seven conditions that we believe need to improve to determine whether equities can continue their upward trajectory or at least establish a market trough.
#1) Peaking coronavirus infection rates: The data has been mixed so far. For instance, daily new coronavirus cases in Italy, at the epicentre of the outbreak in Europe, were 6,153 on the 26 March, down from a peak of 6,557 on the 21 March. However, as testing of population starts to increase, US coronavirus new cases have yet to peak. Looking forward, modelling the rate of infection and quarantining, we expect world ex-China coronavirus cases to peak in April or May. Until there is clear evidence that coronavirus infection rates have topped out, governments will be reluctant to lift population lockdowns, and this factor is likely to remain a drag on markets.
#2) The economic outlook is deeply uncertain: Some high frequency stats give an early glimpse of the impact the coronavirus is having on economies through self-isolation and closure of many non-essential stores. The US jobless claim rose to a record 3.3 million in the latest week, far higher than the previous high of nearly 700k in 19821. Rising unemployment across the globe is sure to follow as government shutdowns force companies to lay-off people. Economists expect a deep contraction to be temporary in the first half of the year and for the global economy to recover in the second half. Yet, there is plenty of uncertainty over these projections, and particularly as there is no historical example for comparison. Therefore, the economic outlook is not a condition that has improved.
#3) Credit liquidity issues in markets: To alleviate illiquidity in markets, The Federal Reserve Bank cut interest rates to zero and restarted its quantitative easing programme to initially buy $700bn worth of treasury and mortgage-backed securities, but soon scrapped the target and left it unlimited. Meanwhile the European Central Bank launched a new €750bn Pandemic Emergency Purchase Program (PEPP) to alleviate “serious risks” relating to the coronavirus outbreak. The Fed also launched new facilities to inject money into US corporate credit markets. So far, the cost of corporate borrowing has yet to come down from elevated levels. That’s largely due to investors’ concerns over the growth outlook, but also because clearing prices have been impaired by tighter regulations introduced since the Global Financial Crisis. This includes the so-called Volcker rule that has lowered the number of market makers providing liquidity to the market. In addition, considerable amounts of capital now follow algorithmic and passive investment strategies, which have led to many investors heading for the exit at the same time. Given the recent volatility and extreme price swings in the corporate bond market, this condition has yet to provide support for equities.
#4) Sufficiently large fiscal stimulus. Governments around the world have stepped-up fiscal policy and this has provided a lift for equities. For example, the US is set to implement a $2trn package worth around 10% of GDP, of which around half will be a permanent stimulus. By comparison, the US fiscal stimulus during the Global Financial Crisis (GFC) was worth around 2.5% of GDP.2 Even conservative Germany has announced a supplementary package worth 4.6% of GDP that involves direct handouts to the private sector. German small firms and the self-employed can claim up to €9,000 over the next 3 months3. In addition to the supplementary budget, the German government will provide debt guarantees to corporates looking to borrow in capital markets.
#5) Less demanding equity valuations: Market valuations have come down considerably. Equities included in the US S&P 500 index now trade on 13.9x forecast earnings over the next 12 months1, a level last seen in 2013. Stocks similarly look extremely cheap relative to bond markets. The UK equity market dividend yield is a record 6.2% points higher than 10-year Gilts4. Even with the heightened uncertainty, equity valuations are at a level that offers a more favourable risk-reward payoff than over a month ago and is a condition that should add support to the market. One risk to these lower equity valuations is that we do not yet know what impact the downturn will have on corporate earnings, as it is too early to start seeing this in analysts’ estimates.
#6) Oversold markets: There are many technical measures of how oversold or overbought a market is. One such measure we follow is market breadth, which considers the number of stocks rising relative to the number of stocks falling in an index. Currently, just 3% of US stocks are trading above their 200-day trend, versus 1% at the worst point during GFC, indicating the market is deeply oversold. Since 1994, we calculate that average forward 1 year returns from these levels are over 20%. 4 Beyond the shorter term, oversold markets support the case for markets to stabilise.
#7) Ample US$ liquidity: Investors are concerned that coronavirus-related market volatility will spill over to foreign exchange rates and that could restrict access to USD funding. To counter this risk, the Fed and five other major central banks, including the ECB, reactivated so called swap lines in the middle of March and expanded access to another 9 other central banks a few days later. These swap lines allow central banks to temporarily borrow dollars from the Fed for an equivalent of local currency. By using swap lines, which were also used during the GFC, this should ease concerns of a USD shortage. However, there is a risk that large borrowers with USD-denominated debt (e.g. China and other selected Emerging Markets) may face USD funding shortages and particularly if the USD appreciates from here against most major currencies. The dollar has weakened over the last few days, but it remains at an elevated level, and poses a risk to markets.
In short, there has been some improvement in the 7 conditions covered here. These include sufficiently large fiscal stimuli by governments around the word, less demanding valuations and oversold market indicators. Peaking coronavirus infection rates and the supply of US dollars in the global financial system appear ambiguous. On balance, we see some ground for equity optimism on a 12-month view, but near-term risks from the growth outlook and issues related to market liquidity remain a near-term drag on markets.
Smith & Williamson has put in place business continuity processes and we will continue to be available to discuss portfolios and markets with all our clients. We do ask for some understanding that some services may have to adapt to these unprecedented steps across our locations.
1 Refinitiv Datastream, data as at 27 March 2020,
2 Bloomberg News, data as at 27 March 2020
3 JPMorgan Chase
4 Smith & Williamson Investment Management LLP/Refinitiv Datastream, data as at 27 March 2020
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