Financial markets experienced their sharpest decline in over two years yesterday, with the S&P 500 and oil prices falling 3.4% and 3.8%, respectively. Meanwhile, 10-year U.S. government bond yields fell to their lowest level since 2016 and the price of another safe-haven asset, gold, reached a seven-year high. The cause for the short-term correction appears to be a jump in the number of new coronavirus cases outside of China on fears that the growth slowdown would be more prolonged than earlier thought, as the outbreak impacts the much larger Asia-Pacific economy and threatens to become an uncontrolled global pandemic without a strong policy response. Only now have investors really begun to acknowledge that a potent trifecta of supply chain disruptions, country border closings, and travel bans would weigh heavily on global growth, as factories temporarily close and consumers in even relatively unaffected areas choose to limit traveling and shopping in public places.
While not irrational, it is surprising how quickly the narrative has changed.
Investors had greeted the new decade with a surge in optimism due to the “Phase One” U.S.-China trade deal, falling Mideast tensions, a strong jobs report, and positive corporate earnings. However, stocks abruptly reversed course and exited January in risk-off mode due to growing concerns over the potential economic damage from the fast-spreading coronavirus. In our view, the market had also simply become overly complacent, having gone since October 2019 without more than a 1% correction. However, stocks then rallied over 4% in early February as President Trump was acquitted, the number of new coronavirus cases in China began to fall, and hopes abounded for easier monetary policy.
Importantly, central banks of the world are united in pumping liquidity into the global financial system, which ought to provide support for stocks. Not to be outdone by the Fed’s $60B monthly purchases of bonds, China has pumped over $240B into its economy to cushion the shock to financial markets from the outbreak. Still, falling bond yields and an inverted yield curve indicate a more cautious outlook for global growth, as does the relative weakness in small cap stocks, commodities, and value stocks – three areas most sensitive to economic activity. We believe investors are likely to remain jittery as long as the global economic ramifications of the viral outbreak are unknown. This fear was obviously magnified yesterday, as investors woke up to the potential for global growth to be sharply lower in the first half of this year. But we see economic activity and stocks rebounding thereafter once it is clear the epidemic is under control and that global manufacturing has bottomed.
So, what lies ahead? According to Cornerstone Macro, history shows that equity markets see a V-shaped recovery after a viral fear recedes, based on the four previous global viral outbreaks (Avian Flu, SARS, H1N1, and Ebola). The Fed is likely to remain accommodative to help offset the short-term decline from China’s contribution to global growth, and we wouldn’t be entirely surprised to see another precautionary interest rate cut or more by the Fed, helping to prolong the economic expansion.
Bottom line, we are monitoring the situation closely for the impact of the uncertainty associated with the developing coronavirus and will adjust client portfolios accordingly. Assuming the worst is avoided, we foresee an acceleration in growth later this year with equities subsequently rallying on strong earnings. Simultaneously, we are balancing a greater preference for stocks with de-risking measures such as improving the quality of our bond holdings and favoring lower-volatility stocks such as dividend payers and multi-asset income funds. In the long run, superior managers focus on preserving investment capital to ensure they have the dry powder to go on the offensive when stocks become more cheaply priced.
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