Coronavirus watch: Our latest assessment of markets as global rout continues
U.S. President Donald Trump’s national address from the Oval Office last night was intended to calm the public and investors. Regarding the latter, it appears to have fallen short of the mark.
Why? The announcement of new U.S. restrictions on travel to and from Europe for 30 days is likely to act as a further drag on the fundamentals for airlines and other related travel industries. In addition, the offsetting stimulus measures that were announced—such as loans to small businesses—either lacked the specificity or size to satisfy the market, and the reaction was swift.
Global selloff continues as bull market comes to an end
The S&P 500® Index briefly fell 7% this morning in the United States, triggering level 1 circuit breakers and a halt to trading for 15 minutes. And the selloff continues to be global in nature. As of mid-morning Pacific time, some European indices are off 10% on the day while the S&P 500, cumulatively, is now down approximately 25% from its peak on Feb. 19. This effectively ends what has been a historical, 11-year bull run.
One silver lining here that should not be lost is that financial market damage can ultimately force a speedier and more forceful policy response. Our clients might recall the U.S. Emergency Economic and Stabilization Act of 2008—a rescue package from the crisis that included the Troubled Asset Relief Program (TARP). This bill initially failed to pass the U.S. House of Representatives on Sept. 29, 2008. Markets went into a free fall in response, and by Oct. 3—a mere four days later—politicians had not only passed it into law, but expanded the size of the program.
Assessing markets through a cycle, valuation and sentiment framework
It’s also useful to take a step back and think about what has happened and how that might inform our preferred positioning going forward. Three questions important questions come to mind in terms of how we think about our portfolios and investment strategy:
- Valuations: Has the selloff improved the skew of potential returns on risky assets?
- Sentiment: Is there evidence of a capitulation or panic that suggest risk premia are more attractive?
- Cycle: Can we formulate a differentiated view on the economic and earnings damage from COVID-19?
Our assessment of equity market valuations—on a medium- to longer-term horizon—has moved markedly. We entered this selloff with the understanding that the U.S. equity market was very expensive. Based on current pricing, interest rates and earnings estimates, the U.S. equity market is now trading in a range that we would judge to be fair value. From a global standpoint, we view equities as now cheap, with particularly large and unusual discounts being priced in the UK equity market, for example.
Similarly, high yield credit spreads, as measured by the Bloomberg Index—which were unusually tight and unattractive in mid-February—blew out to 660 basis points as of yesterday’s close (a level of compensation moderately above long-run historical norms). Meanwhile, safe haven assets look more expensive. The 10-year Treasury yield, currently trading at 78 basis points, effectively already embeds a view that the U.S. Federal Reserve will cut interest rates to zero and keep them there for a very long time. While that view may prove to be correct, the balance of risks and skew of outcomes this close to the lower bound suggests more upside than downside potential to yields from here—assuming we get to the back half of virus-related impacts and see risk aversion normalize.
We evaluate market sentiment with a lens on price momentum and whether the collective psychology of investors has pushed to an extreme of panic or euphoria. While price momentum for risky assets has deteriorated, a number of technical, positioning and survey-based indicators suggest to us that we are very close to one of those panicked extremes today. There are no guarantees in finance, but historically these episodes have offered long-term investors an opportunity to collect extra risk premia when other investors are afraid. Times like these are when clients can be rewarded by staying invested and maintaining conviction in their strategic plans.
Finally, on the business cycle, as we’ve written about before, we do not claim to have any unique insight on the future contours of this virus. That is, in part, informed by a humble recognition that many of our expertise lies in the fields of economics and finance. But we have also talked to medical experts on this issue, who have told us that forecasting and timing the extent of the virus is effectively impossible.
We recognize that there could be potentially severe disruptions to global economic and earnings growth over the next few months as factories are closed and travel is restricted. But whenever we do get on the back side of these virus effects, we believe we’ll likely enter an environment ripe with pent-up demand and aggressive monetary and fiscal tailwinds at our backs.