Insights

Investment Outlook April 2020

  • Written By: Daniel Casali
  • Published: Mon, 06 Apr 2020 12:00 GMT

Rising market risks from the coronavirus outbreak

Global equities have fallen at a rapid pace since peaking in mid-February. It took just 19 days (on 12 March 2020) for the US S&P 500 index to enter an equity bear market (defined as a drawdown of more than 20%). This is the fastest on record from data going back over 100 years. We are in the midst of an unprecedented event for society and markets. This makes it difficult to give any short-term predictions with any certainty. These are difficult times, but we are encouraged by the scale of response by policymakers.

There is much comparison between the current Global Coronavirus Crisis (GCC) and the last bear market during the Global Financial Crisis (GFC) in 2008, but there are many differences between these sell-offs. During the GFC, investors were worried about banking sector counterparty risk leading to systemic risk in the financial system. In contrast, the GCC has started out as a health scare shock. However, it has now turned into a liquidity crisis and could potentially morph into a financial crisis, like the GFC, if government lockdowns are extended for a long period of time. While the coronavirus outbreak is the catalyst for the sell-off, years of ultra-low interest rates have encouraged long-term investors to take on more risk than they would have normally done in order to seek returns. Clearing prices have also been impaired somewhat by tighter regulations introduced since the GFC. This includes the so-called US 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. This has added to market volatility and extreme price swings.

Looking forward, there is the supply-side shock coming from China and the locking down of whole advanced economies (e.g. Italy, Spain, France and the UK). This will inevitably lead to lower demand growth too. In its March Fund Manager Survey, Bank of America noted that fund managers reduced their global growth expectations by the biggest monthly amount from available data going back to 1994. Lower growth and company earnings’ expectations adds stress to financial markets.

Policy makers have strongly reacted to recent market volatility and new measures of unprecedented size are being released daily. The Fed 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 ECB launched a new E750bn Pandemic Emergency Purchase Program (PEPP) to alleviate “serious risks” relating to the coronavirus outbreak. The Fed also reinstated a facility that provides more funding for the US commercial paper (CP) market.  This is an important source of short-term finance for companies to draw on if banks become unwilling to lend to them. The Fed’s CP facility should also alleviate the need for companies to run down cash assets, which unless prevented could help spread contagion through US (and global) financial markets. The ECB and BOE have also announced similar CP facilities.

The bottom line is that global central banks are finally injecting liquidity direct to the corporate sector, reducing credit risk and providing a backdrop for financial markets to stabilise.

Aside from central banks willingness to provide liquidity to financial markets, government around the world have stepped-up fiscal stimulus. UK Chancellor, Rishi Sunak, recently rolled out a £350bn rescue package to keep Britain’s businesses and workers afloat through the coronavirus crisis. Meanwhile, the Trump administration has  introduced a $2trn-plus fiscal package to backstop the US economy. European governments (including fiscally conservative Germany) have also introduced policy to support their respective economies.

Markets continue to look for more coordinated fiscal and monetary responses by the world’s major economies to stabilise the global economy and keep markets liquid,
while also containing the coronavirus outbreak.

Encouragingly, population quarantines have led to a plateauing in the number of coronavirus cases in China and the recovery rate of those infected has risen to 85%. Restrictions on China’s population are being eased. High frequency stats such as coal consumption, daily passenger volumes show that Mainland economic growth is gradually beginning to recover. There is a risk of the virus reappearing, but we all should be encouraged to see how effective 6 weeks of containment has appeared to be.

Should coronavirus cases top-out in the coming months, this should create an environment for the market to find a trough. Once that happens, less demanding equity
valuations, incremental policy easing and a loosening in travel restrictions will provide an opportunity for economies to recover and for equity markets to rally from their currently oversold positions.

Global equities have fallen at a rapid pace since peaking in mid-February. It took just 19 days (on 12 March 2020) for the US S&P 500 index to enter an equity bear market (defined as a drawdown of more than 20%). This is the fastest on record from data going back over 100 years. We are in the midst of an unprecedented event for society and markets. This makes it difficult to give any short-term predictions with any certainty. These are difficult times, but we are encouraged by the scale of response by policymakers.

Given the extent of the market moves from this Global Coronavirus Crisis (GCC) in 2020, comparisons are being made to the last bear market during the Global Financial Crisis (GFC) in 2008. There are differences between both these sell-offs. During the GFC, investors were worried about banking sector counterparty risk leading to systemic risk in the financial system. In contrast, the GCC has started out as a health scare shock. However, it has now turned into a liquidity crisis and could potentially morph into a financial crisis, like the GFC, if government lockdowns are extended for a long period of time. While the coronavirus outbreak is the catalyst for the sell-off, years of ultra-low interest rates have encouraged long-term investors to take on more risk than they would have normally done in order to seek returns. Clearing prices have also been impaired somewhat by tighter regulations introduced since the GFC. This includes the so-called US 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. This has added to market volatility and extreme price swings.

Looking forward, there is the supply-side shock coming from China and the locking down of whole advanced economies (e.g. Italy, Spain, France and the UK). This will inevitably lead to lower demand growth too. In its March Fund Manager Survey, Bank of America noted that fund managers reduced their global growth expectations by the biggest monthly amount from available data going back to 1994. Lower growth and company earnings’ expectations adds stress to financial markets.

Policy makers have strongly reacted to recent market volatility and new measures of unprecedented size are being released daily. The Fed 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 ECB launched a new

E750bn Pandemic Emergency Purchase Program (PEPP) to alleviate “serious risks” relating to the coronavirus outbreak. The Fed also reinstated a facility that provides more funding for the US commercial paper (CP) market. This is an important source of short-term finance for companies to draw on when banks may be unwilling to lend to them in this environment. The Fed’s CP facility should also alleviate the need for companies to run down cash assets, which unless prevented could help spread contagion through US (and global) financial markets. The ECB and BOE have also announced similar CP facilities.

The bottom line is that global central banks are finally injecting liquidity direct to the corporate sector. This helps to reduce credit risk and increases the chances that the market can stabilise from here.

Aside from central banks willingness to provide liquidity to financial markets, government around the world have stepped-up fiscal stimulus. UK Chancellor, Rishi Sunak, recently rolled out a £350bn rescue package to keep Britain’s businesses and workers afloat through the coronavirus crisis. Meanwhile, the Trump administration has introduced a $2trn-plus fiscal package to backstop the US economy. European governments (including fiscally conservative Germany) have also increased fiscal support for their respective economies.

Essentially, markets are looking for a more coordinated fiscal and monetary response by the world’s major economies to stabilise the global economy growing and keep markets liquid, while also containing the coronavirus outbreak.

Encouragingly, population quarantines have led to a plateauing in the number of coronavirus cases in China and the recovery rate of those infected has risen to 85%. Restrictions on China’s population are being eased. High frequency stats such as coal consumption, daily passenger volumes show that Mainland economic growth is gradually beginning to recover. There is a risk of the virus reappearing, but we all should be encouraged to see how effective 6 weeks of containment has appeared to be.

Should coronavirus cases top-out in the coming months, this should create an environment for the market to find a trough. Once that happens, less demanding equity valuations, incremental policy easing and a loosening in travel restrictions will provide an opportunity for economies to recover and for the market to rally from oversold positions.

Ref: 49420eb

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.

Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.

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