From the outbreak of Coronavirus in China, markets had initially responded in quite a muted fashion. There was a belief that this was mostly a Chinese or at worst an Asian problem, that would impact on global supply lines. Secondly investors mistakenly compared the impact of the virus to the likes of SARS, MERS and Ebola. And thirdly there was a general view that economies were strengthening as trade tensions eased.
That narrative was discarded once it spread into Europe and other developed democracies. With worsening data about the speed and fatality levels in developed economies and the WHO declaring it a global pandemic, markets have been falling significantly – pricing in a worse economic outcome than had been originally envisaged. In recent days, markets have collapsed, rallied and collapsed again as news flow caused market opinion to swing wildly.
Figure 1: Global equity markets & the new cases of Coronavirus
Source: Bloomberg 19/3/2020
The impact of Covid-19 and its secondary effects have set the global economy back onto a weakened trajectory. The many negatives that are playing out at present, point to a near certainty of recession in developed economies in H1 2020. While impossible to predict with accuracy, our view is, on balance, that this will be followed by recovery in the second half of 2020 as disrupted supply and demand normalise.
On the assumption that the Chinese pattern of a 2-3-month timeframe for the virus to peak repeats, the worst impact in advanced economies will hopefully be relatively short-lived (even if it proves somewhat longer given the greater challenges western societies may face). While that outlook is heartening, concerns remain whether we will yet see further secondary impacts that could tighten financial markets – all the more reason why the actions by central banks and governments are now so critically important to financial markets. Central bank rate reductions began with the Chinese central bank 0.1% cut, the BOE’s 0.5% cut and as of Sunday 15th the Fed cut to zero and increased Treasury and agency securities purchases by $700 billion. On Wednesday 18th the ECB outlined a €750 billion bond buying programme.
However, cuts and liquidity measures can’t do anything to slow a virus, what they can do is create a backstop for financial markets and lessen the risk of further tightening of financial conditions. What was clear from the ECB president Lagarde’s “Fiscal First” comments, the scale of fiscal policy reaction from governments is now critical and markets are clearly signaling this is needed to avoid a deeper recession emerging. The scale of commitments being made has been increasing with the most notable being the US $2 trillion stimulus package.
A downturn distinguished more by speed than scale
The impact in markets stands out amongst the history of market downturns more for its speed than its scale. Markets have moved exceptionally quickly to price in a very high probability of recession resulting from the virus and its secondary impacts. By comparison to downturns in equity markets in the past half century.
Have we seen the end of this?
If markets have fallen with unprecedented speed, is it reasonable to expect the rebound to happen at breakneck speed also? Perhaps but it is, on balance, unlikely.
Equity markets have oscillated wildly in recent days with heavy losses being followed by impressive rallies repeatedly.
However, as we have not seen the peak outside China, we are likely to see a great deal of weak macro data in the coming weeks. Some of the hard data emerging so far is showing the Chinese economy to have suffered worse than had been anticipated. It now looks likely that the Chinese economy will contract in Q1 for the first time since records started in 1989
So, despite market volatility and heavy losses in equity markets, it is the evidence in the data that really counts, not just the sentiment. Is all of this already priced in? Perhaps a good deal is as we know it’s coming, but perhaps the magnitude will yet surprise us, as it already did with the Chinese data. Equally the starting point in equity markets wasn’t a cheap early cycle one, quite the contrary – we came into this shock on the back of the strongest year in a decade, creating an added vulnerability. That uncertainty and downside risk is a recipe for continued volatility for some weeks and months to come.
What sort of market are we facing into?
We have reached the 20% loss level that characterises bear markets (at time of writing global equities were down 26%). But what type of bear? Goldman Sachs1 has characterised ‘bear markets’ into 3 types: –
1. Structural bear markets – the nastiest of the three types with 50%+ losses, these bears start with structural imbalance in the economy and are the deepest and longest lasting. The Great Financial Crisis of 07-09 was one such event, so too was the Oil crisis of 1973
2. Cyclical bear markets – a more normal style downturn, usually interest rate increases and falling earnings are prominent features. 30% type downturns with recovery still taking a number of years
3. Event-driven bear markets – as the name suggests these tend to occur because of a shock to the system, such as a conflict or a viral outbreak. Losses are typically c.30% but the period of losses tends to be shorter (on average 9 months) and the recovery period being 15 months (in nominal terms).
Source: Bear Essentials March 2020, Goldman Sachs
At this juncture we see this as the third type – as it is very clearly directly a result of the pandemic nature of the virus. That sets a base case for how long before we see a resolution of this, and recovery periods for investors (15 months nominally is the historic average). As with all ‘base cases’, there are risks that it proves more challenging especially if secondary effects impact on the financial system more than is being prepared against. We have already seen a second economic shock with the Saudi/Russian breakdown although the impacts of this will be a mix of negatives for the sectors and countries impacted and a broader positive for consumers.
What markets need to see for this to turn around (sustainably?)
Our view is that we need to see four components in evidence for a sustained recovery and reduced volatility
(a) decline in the rate of growth in infection rates in developed economies
Given the evidence from both China and Italy’s experiences, estimates are varying between 2-4 months before we see a decline in the rate of infection from the virus in western economies. That probably takes us until May/June.
(b) Fiscal policy action
There has been considerable commitment from governments to increase fiscal spending, but markets continue to look for implementation of this. Most notable was Germany which made a ‘whatever it takes’ style commitment, breaking with decades of budget balancing. The full scale of this response may need to be of this character globally. With $2 trillion being approved in the US, so we’ll see this sort of spending.
(c) Sustained central bank support for liquidity
For some time, we have commented on the declining marginal effectiveness of monetary policy and ECB President Lagardes comments (“Fiscal First”) gave a very clear indication of where the European Central Bank sees the onus landing (and markets seem to agree). However central bank actions to protect the financial system are vital and we have seen very considerable actions taken to ensure liquidity is available to the financial system; with the Fed pulling out all the stops cutting rates to zero and a resuming purchases of Treasuries and Agency mortgage back securities. This was then followed by the ECB’s announcement of plans to buy €750bn of debt. Very clearly this is being done to avoid a third economic shock coming into play – a deeper dislocation in financial markets, and it seems probable that the central bank actions will achieve this.
(d) Strong evidence of a return to work & normality in China
According to the WHO, China is no longer the epicenter of the virus, that unwelcome title has passed to Europe. Nonetheless hard data of the impact is now emerging from China and appears to have been worse than anticipated. Industrial output for January and February was down 13.5% year on year, retail sales were down by 0.5% and fixed asset investment dropped 24.5%. Contrasting that however there is some evidence coming through that Chinese industry is getting back to work. The Chinese government has indicated that 78 million migrant workers are now back to work (that’s 60% of those who had gone home for the Lunar New Year) and Hubei recommenced normal production.
Implications for investors
There are three core pieces of advice that we make at times like this – of its nature this is general, cannot be applied to all cases, and will depend on each client’s ongoing investment objectives, their timeframe and both their attitude to risk and capacity for investment loss.
Review your original objectives with a long-term focus
When you invested first you will have given consideration to the returns you expect to achieve and the level of risk or volatility you are happy to experience. The events of recent weeks are very unwelcome for any investor, but, as a general point, staying invested through periods of volatility is the best long term approach to take. This may also mean extending the length of time you invest for, and given the scale of losses in this downturn, this may be a necessary consideration. The main circumstances in which you should change tack are (a) if your objectives have changed or (b) your tolerance for loss is changed.
Review your portfolio for diversification
Being diversified in your portfolio across asset classes and strategies is dull but reliable and usually comes to the fore at times like this. Well diversified conservatively focused portfolios have not suffered losses anything near the headline stock market falls, in particular as government bond markets have performed reasonably well.
Recognise that these near-term circumstances will influence your thinking
When facing a downturn in investment values, especially one so rapid, we can all start to change how we think about long term investments. Some of this can be an emotional response and a very understandable one; most experienced investors train themselves to avoid making decisions in such circumstances.
Questions or need Advice
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Warnings and Disclaimers
Warning: If you invest you may lose some or all of the money you invest.Warning: The value of an investment may go down as well as up.
Warning: Past performance is not a reliable guide to future performance.
Warning: Investments may be impacted by changes in currency exchange rates.
While great care has been taken in its preparation, this information is of a general nature and should not be relied on in relation to a specific issue without taking financial, insurance or other professional advice. If any conflict arises between this information and the policy conditions, the policy conditions will prevail. Advice First Financial Services Ltd believes the information above to be accurate, but Advice First Financial Services Ltd does not warrant its accuracy and accepts no responsibility whatsoever for any loss or damage caused by any act or omission made as a result of this information.
You should obtain independent professional advice before making any investment decisions. Any expression of opinion reflects current opinions as at March 2020. Any opinion expressed (including estimates and forecasts) may be subject to change without notice. This article is based on information available as at March 2020.
Advice First Financial Services Ltd trading as Advice First Financial is regulated by the Central Bank of Ireland.
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