investors are taking necessary precautions
There’s plenty for investors to reflect upon in the final week of January. The escalating coronavirus has now killed at least 81 people in China and infected more than 2,500, with cases reported in a number of countries, including the US, South Korea, Hong Kong, Singapore, Taiwan, Australia and Canada.
At such times, the growing scale of human suffering places volatile markets in the shade. Here, the FT’s visual data team has created a map that tracks the spread of the virus in China and beyond its borders:
The spread of the virus has triggered a strong reaction across markets, illustrating how fears about economic growth are casting a cloud over the bullish new-year thesis that investors have seemingly embraced. Concern is focused on China’s economy suffering a first-quarter blow, and what that entails for this year’s outlook.
Having rallied without much interruption since October, global equities (up around 14 per cent at the peak for the FTSE All-World index during this period) were due for a correction. But it bears repeating that quality and growth companies have led this equity rally, leaving economically-sensitive and value companies behind. From a positioning standpoint, this suggests an equity market that is not fully confident about a robust economic bounce this year — and such scepticism was evident even before the China virus erupted.
The flip side of a bullish 2020 equity trade is that many began the year expecting higher government bond yields and a weaker US dollar, particularly versus emerging market currencies. Such positioning has been fading of late — chiming with the lagging tone for cyclical equities this month — given the latest warning shot across the bow of the global economy.
Now perspective is important. Past viral episodes have been contained and have fortunately not left much of a mark on economic activity.
As Russ Mould at AJ Bell notes:
“Previous experience of global health crises does at least suggest there could be a fairly rapid recovery once the number of cases has peaked.”
JPMorgan, which has assessed the market impact of past outbreaks, highlights Russ’s point in this graph:
In the interim Russ cautions:
“The difficulty for investors is that it is extremely difficult to predict what turn of events might take in the coming days and weeks. Until there are signs the virus has been contained equities look set to be dogged by uncertainty.”
Hopefully the virus is contained and global growth prospects are not derailed. That still leaves investors who hold risk assets having to wrestle with just what kind of economic rebound ensues over the coming months. Mark McCormick at TD Securities notes their tracking model comparing MSCI World equities versus global purchasing managers’ indies “implies a plus 20 per cent gap”, as shown here:
Mark expects a reset rather than a rejection of the new-year bullish thesis:
“The global growth data hasn’t turned fast enough to justify the optimism priced in across markets”. He expects “the market takes a step back from the reflation narrative, reflecting a mix of stretched positioning, excessive momentum, and frothy valuations”.
That appears the current course. Here’s how things look across key markets, with some key events in the coming days, such as US tech earnings and policy meetings by the US Federal Reserve and the Bank of England.
The US Treasury 10-year yield is now approaching 1.60 per cent (a level previously seen back in early October) while the 10-year German Bund is nearing minus 0.4 per cent. Earlier this month, talk of these benchmarks testing 2 per cent and zero respectively was popular.
Looking ahead for the US Treasury market, Ian Lyngen at BMO Capital Markets writes:
“The subsiding of coronavirus fears will ultimately be an event worth 20-30 basis points in 10-year yields, however, if rates bottom closer to 1.50 per cent (or below) the upper bound of 1.95 per cent has little chance of being breached.”
Italian yields were the big movers on Monday with the 10-year bond nearing 1 per cent, after lagging of late. A defeat for rightwing leader Matteo Salvini’s party in a key regional election over the weekend has reassured investors that Italy’s coalition government can hold power.
In contrast, various growth proxies alongside oil and companies in the airline, hotels, luxury and mining sectors were under pressure. In Europe, an unexpected drop in German business confidence for January hardly helped sentiment.
China’s offshore renminbi exchange rate weakened 0.6 per cent to Rmb6.9664, as the US dollar broadly strengthened across the board (with the notable exceptions of the usual havens of the Japanese yen and Swiss franc). Meanwhile, the price of gold is nearing $1,600 an ounce, building on this month’s already robust performance.
For Wall Street, the S&P 500 appears in line for a test of its 50-day moving average at 3,198. The market rallied through this measure of momentum back on October 10, so one can argue it’s time for another test, although should this happen it would only mark a drop of 4 per cent from its recent record close.
Indeed, Morgan Stanley suspects “the first correction since October has begun” and thinks it should stay “contained to 5 per cent or less for the S&P 500 as liquidity remains flush and high quality/low beta/defence (ie, S&P 500) outperforms lower quality/high beta/cyclicals (small-caps, EM, Japan, Europe)”.
Against this backdrop, earnings season picks up the pace this week, with Apple due on Tuesday, while Microsoft, Amazon, Facebook and Tesla also reporting before the end of the month.
JPMorgan notes that while earnings season for Wall Street has seen strong beats, strong guidance for the coming quarters is also crucial. The bank notes:
“Given significant growth-optimism now priced into equity values, there is a risk that a less than exceptional outlook could disappoint investors. The most vulnerable are momentum-growth stocks given their sharp re-rating on global growth recovery and trade deal prospects.”
This week’s upcoming slate of results and guidance from US tech giants certainly matters in this regard. Tech has led the rally, with the sector up 25 per cent since early October versus a 14 per cent return for the broad market. That has pushed the tech sector’s price-to-forward earnings to 22.7 times versus averages of 17.5x and 15.1x over the past five and 10 years respectively, according to FactSet.
Morgan Stanley highlights just how concentrated returns for the S&P have been:
“The top five contributors (Apple, Microsoft, Alphabet, Facebook and Mastercard) contributed ~31 per cent to the overall change of the S&P’s market cap over the last year, about as much as the next 30 contributors combined.”
More broadly for Wall Street, Nick Colas at DataTrek makes an important point that although many companies have beaten revenue expectations, this “is not flowing through to bottom line outperformance” and margin pressure remains the story for many in the S&P 500. Nick adds:
“Margin pressures are eating into corporate profitability and limiting upside earnings surprises. This is a contributing factor to analysts cutting their Q1 2020 earnings expectations, which begins to resolve our concern that the Street is too optimistic on the first half of 2020.”
Corrections are a healthy aspect of any bull market and that’s not a bad thing for equities from here. Buying quality and growth companies after a dip has been a successful approach over the past decade. But as Morgan Stanley notes:
“If an economic recovery is truly coming, we would own those value cyclicals, which are most leveraged to improvements in economic growth. Those stocks appear relatively cheap today.”
Quick Hits — What’s on the markets radar
When this week’s Federal Open Market Committee meeting concludes on Wednesday, attention will focus on the tone of Jay Powell’s press conference. Any mention of the Fed’s balance sheet and Treasury bill purchases has important considerations for markets. Bond traders expect a gradual slowing in the current $60bn pace of monthly bill buying from April.
Wrightson Icap points out:
“The Fed needs to provide more clarity about its plans for managing the transition from its current aggressive purchases to more moderate organic balance sheet growth at some point later this year. The single most important question is what the FOMC’s interim target for reserve balances in the second quarter will be.”
While the Fed was initially looking at pushing bank reserves higher to $1.45tn, Wrightson Icap shows reserve projections through mid-July in its chart:
“Our guess is that the Fed at present thinks the reserves threshold at which it could make the transition from aggressive balance sheet expansion to moderate organic portfolio growth is somewhere in the $1.6tn to $1.7tn range.”
Whether bill purchases constitute quantitative easing is a topic of much debate. Buying bills swaps a quasi-cash asset for cash and therefore should not be driving up equity valuations, is one argument. Although Robert Kaplan, the Dallas Fed president, recently said the bill-buying was a derivative of QE and may be causing some QE-like effects for asset prices.
In that regard, it will be interesting to gauge the equity market reaction that follows an eventual tapering of bill purchases.
Wrightson Icap notes:
“If traders are convinced that ‘QE’ (however they define it) drives equity prices higher, then Fed balance sheet growth will reinforce any positive momentum the stock market might already have. The Fed’s reserve injections are not the only — or even the primary — reason for the recent rise in the S&P 500, but probably did strengthen investors’ confidence on the way up.”
The Bank of England meeting on Thursday remains very much “live” in terms of a rate cut or not. The current tone in markets may well push the needle for an insurance ease of 25 basis points from policymakers. The yield on two-year gilts dipped below 0.4 per cent on Monday, near the lows of the summer, while the pound is holding above $1.30 against the dollar.
Brent crude, the international benchmark, fell below $59 a barrel on Monday, plumbing to a three-month low, illustrating how growth concerns are weighing on an oil market awash with supplies.
David Sheppard, the FT’s energy editor, writes that Opec and its allies have held preliminary discussions about making deeper cuts to oil production if the fallout from the coronavirus crisis keeps weighing on crude prices. “They are prepared to do anything if there is a need,” one senior Opec source told reporters on Monday. “They are watching the market closely.”