Markets have experienced a significant correction this past week as investors try to assess the impact of the coronavirus (COVID-19) outbreak.
Admittedly this is the “Black Swan” event no one had expected in 2020. It has occurred at a time when the outlook for global growth had been improving, interest rates have continued to remain low, with accommodating financial conditions. It has also come at a time when many equity markets had reached record highs through the beginning of February (just seven days prior in some instances) and arguably valuations in most assets were stretched.
The size of the moves witnessed in this past week, particularly for equity markets, compares to periods experienced at the height of the 2008 GFC. Fixed Income and FX markets have also reacted though much of the shift in sentiment last week has been experienced across equity markets.
In response to the ongoing rise in new cases across regions, governments have significantly increased their awareness in an effort to address the spread of the virus. The death toll has risen with the majority of cases in China1.
Given the potential severity of the current outbreak being priced by markets, one perspective is to consider that the World Health Organisation (WHO) currently attributes between 300,000 and 650,000 deaths per annum from the annual influenza virus (with 3 to 5 million cases of severe illness)2 and the current mortality rate of COVID-19 appears to be no more significant from a humanitarian standpoint. The fact that there is currently no known treatment available has increased the significance of this latest outbreak until such treatment exists.
Factory closures across some manufacturing sectors (primarily in China) and travel related bans now being instigated in other regions outside of China/Asia, will certainly impact global economic activity, company supply chains and in turn on company profits going forward. Cash flows for many companies are likely to be impacted in the short term, particularly given the shorter inventory cycles that many now operate under (aka ‘Just in Time” strategies). Twenty days following this year’s China Lunar New Year was the reported low point for economic activity in China due to mainland quarantines and travel restrictions. Recent indications show that economic activity is improving but slowly.
The magnitude of falls across markets, in particular equity markets this past week, appears to price in not just a likely recession in most developed regions but also a minimum 15%-20% fall in company earnings.
The fall in bond yields and additionally shorter term interest rates suggests markets are expecting more interest rate cuts from Central Banks in an effort to support growth and steady financial markets. Interest rate cuts of up to of 0.75% are now priced for the US Federal Reserve this year (prior to February markets priced less than 25% probability of a 0.25% cut for 2020) while the RBA is now expected to cut rates by a further 0.5% beginning in April. The pressure now for further policy support from both Central Banks and Governments to spend, has increased and is yet to be fully reflected in equity markets post the moves lower this past week.
While infection rates are now appearing to slow in China, COVID-19 infections are now rising outside of China.
There have been fewer daily deaths and fewer new cases in the past several days in China. The WHO-China joint mission press conference on 24 February3 noted their belief that the number of new COVID-19 cases in Wuhan (ground zero of the recent outbreak) has dropped since January 23, suggestive of the disease having now potentially peaked in China. However the clear concern for markets, at present, is the rapid pace of outbreaks in other regions with over 3000 confirmed cases in South Korea and over 300 now in Italy. At the time of writing, total confirmed cases had reached 84,124 across over 60 countries with a total mortality rate of around 3.0%. An overwhelming majority of these, however, remain centred in mainland China (93.7% of all reported cases), while South Korea and Italy now account for 2.7% and 1.1% of total global infections. At the time of writing, Australia had reported 23 confirmed cases, two deaths and 11 recoveries4.
There does not appear to be an imminent medical solution yet, raising the concern of the outbreak having a more protracted impact on communities and economies. The WHO has recently highlighted a experimental drug (remdesivir) from US biopharmaceuticals company Gilead Sciences which may have some efficacy against COVID-195. But the company is only just starting clinical trials, meaning it would likely be another several weeks to months before the drug comes to the market. Timing is likely similar for other experimental vaccines given few are near human trials. For mainland China, mortality rates, whilst they have been drifting higher from (2.2% to 3.5%) over the last month, are heavily skewed towards the older population particularly those with pre-exisiting conditions. Individuals below 50 and/or those with pre- existing conditions have mortality rates well below 2% and near 0% for people below the age of 40.
According to WHO, the current fatality rate however is well below that of SARS (which was around 10%)6 and MERS (around 33%)7 of the early-to-mid 2000’s and 2010’s though the rate of contagion and spread of this coronavirus is significantly higher.
In addition to the spread of the virus it is the potential disruption and impact on economic activity which has seen equity markets fall further this past week.
Coming into 2020, we were mildly positive longer term for asset markets. Though we saw a decrease in our 10 year expected return assumptions at the beginning of this year following such a strong year in 2019 for asset returns, we expected a positive equity risk premium and equities remain relatively attractive compared to other assets classes. 2019 was also a period where very strong equity returns (+28.0%) for the US S&P 500 Index was accompanied by weak profit growth (earnings per share growth for the US was just 2.9% in 2019)8. This left the starting point for most equity markets near full to fair value with expectations for lower returns and a catch up in earnings growth to support our mildly positive outlook.
Additionally the US equity market finished 2019 at a risk premium to the 10 year US bond of around +2.5% which has now increased to +3.6% as at the end of February. These are relative levels not seen since the European debt crisis of 2011-2013. Further, after adjusting for the current market implied (e.g. -20%) fall in future company earnings, and given bond yields continue to hold at current levels, the US equity market would still be trading at a +2.6% equity risk premium.
As a result it is difficult for longer term investors to fundamentally have a negative outlook for equity markets at such levels given Bonds are currently priced to return at best +1.0% p.a. over the next 10 years.
As we consider the current market impacts of the COVID-19 induced correction, admittedly, we do not know when or how the current outbreak may be contained. Equity markets have already priced in a significant adjustment down in growth and profit expectations, yet historically events such as these have seen markets experience a recovery over the next 6 months. Additionally the impacts of the latest outbreak have so far only impacted the global supply side, whilst the incoming 2020 economic environment and fundamental backdrop (low interest rates and inflation, fiscal stimulus in China, robust demand in the US and potential for increased fiscal stimulus across other regions) still remains a positive and may yet provide even more support should governments and policy makers look to pre-empt a global growth slowdown from here.
Whilst we admit our portfolios are not immune to periods of negative returns, they are diversified across asset classes which provides some protection for investors to falls in equity markets as we witnessed last week. We continue to hold our portfolio positions in line with our strategic targets and expect to continue rebalancing towards these targets through the current volatile period. For long term investors we advocate to remain invested.
The current period of volatility could continue, however markets have discounted significant underperformance with little consideration to any recovery in growth towards the end of this year.
 BT Investment Solutions 2020 Capital Market Assumptions, market data source; Refinitiv/ Thomson Reuters
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Information current as at 5 March 2020. © Westpac Financial Services Limited 2018.