What is happening in markets today?
European Equity markets have fallen by another 8% today, with US Equity markets also set to fall by at least as much. Markets are derating further as the Coronavirus continues to spread and the likely consequences on the world economy remain anyone’s guess at this point in time. In this regard, we will publish in the coming days our scenarios for the months ahead which should help us and our clients navigate this environment. What do we mean by derating? Put simply, if one assumes that earnings will not grow in 2020 in the US compared to last year, the S&P500 at a 2500 level today would trade on 15.7x forward earnings. Clearly it is not as simple as markets tend to discount earnings many years out but in an environment where the market has no visibility past a few months, the 15.7x multiple is not low enough compared to history at similar times of stress. For example, in the Global Financial Crisis (GFC) US Equities traded as low as 10.5x multiple. This can explain why the market may continue to fall short term, even if investors believe the Coronavirus to be ultimately temporary.
Turning to credit markets, we continue to see credit spreads widening, with particular stress in the US High Yield segment.
Credit spreads have now widened to levels just around the 2015-2016 energy/China crisis and in some cases above the 2011 levels. Indeed, high yield spreads stand at 730bps in the US and 630bps in Europe, while investment grade spreads are at 229bps in the US and 173bps in Europe. This means that US and EUR high yield are pricing a default rate of at least 9% if one adjusts for a recovery rate of around 40% and a liquidity premium. While we have experienced historical default rates and credit spreads at higher levels (in the GFC, default rates and credit spreads peaked at c.15% and 2000bp, respectively), it’s worth noting current spread levels are pricing a meaningful amount of distress in markets already. However, we should keep in mind the challenging liquidity conditions for credit as an asset class, with notable widening of bid asp spreads and ETF prices trading at 3-4% discounts to net asset value.
Finally, traditional safe haven assets continue to prove valuable as diversifiers, namely US Treasuries, the Japanese Yen and, to a lesser extent, gold. The long-term negative correlation between traditional safe havens and risk assets is intact, in our view, as is their role as diversifiers in a portfolio context.
What is driving the market action?
A combination of Coronavirus developments and policy makers’ actions.
What do we observe at the virus level?
Over the last few days we have heard that more countries are moving to proper lockdown measures (Spain). Many more are likely to follow. Why? Evidence is mounting that the countries where complacency towards the virus was initially high, such as the US, the UK and many European countries, are seeing over 25-30% daily growth rates in the number of new cases. With Italy begging world leaders to not repeat the mistakes it made and the initially-embraced ‘herding immunity’ approach failing to work, we need to see other countries embrace much needed lockdown measures, such as the US and UK.
As lockdown measures get enacted in certain countries, the reproduction rate (RO) of the disease there is falling. Our analysis shows that this can rapidly be the case when countries take proper measures. Lockdown measures have the merit of bringing some certainty, markets love certainty but loathe uncertainty as we have seen in recent weeks.
What are we observing amongst policymakers?
Several central banks have been cutting rates and enacting monetary easing measures in the last 24 hours (Bank of Japan, Bank of New Zealand, US Fed).
Clearly the biggest news was the multiple easing measures announced by the US Federal Reserve, including:
- Cutting Interest rates to a 0-0.25% range, back to the lows of the global financial crisis effectively.
- Restarting quantitative easing with over $700bn of asset purchases announced, including at least $500bn of US Treasuries and at least $200bn of agency mortgage-backed securities.
- Other easing measures include: Reducing the discount window funding rate to 0.25%. Reducing the bank’s reserves requirement to 0 and effectively asking banks to use their balance sheet to help the system. And lowering along with 5 other major central banks the spread over overnight interest swap rate for dollar liquidity to 0.25%.
Why did the Fed announce so much? The major reason indicated by Fed Chairman Powell is that last week signs of stress emerged in the US Treasury market, which is by far the most important market in the world.
What do we recommend at this stage and what are we monitoring?
We maintain our existing views that moderate risk levels in portfolios are appropriate at this point in time. Our neutral to slightly positive stance regarding equity is maintained based on the view that the virus impact will be transitory and that we will see a better second half of the year. We continue to watch the virus data closely and want to see more widespread lockdown measures all over the world. The Monetary Policy responses we are seeing should all be supportive and we do want to see further fiscal measures particularly in Europe and in the US.
Diversification remains the only free lunch in investing and in this regard we maintain our recommendations for some defensive assets such as US Treasuries and foreign currencies, all of which have somewhat cushioned the blow. Within equities, we maintain overweight positions in sectors like IT and healthcare while underweighting more cyclical sectors.
As equity markets continue to de-rate and credit spreads to widen, we are now increasingly looking for opportunities to re-allocate to risk assets. In this regard, we are currently assessing whether the current level of either equity prices or credit spreads is sufficiently attractive to compensate for the current high volatility. Namely, it is reasonable to expect further earnings downgrades and a pick-up in default rates from current levels, which might put further pressure in valuations. It is right to “be greedy when others are fearful” as Warren Buffett famously said, but we should be respectful of market momentum.
We will continue to evaluate market opportunities as they arise and will communicate any changes to our views accordingly If you have any questions please contact your usual Brown Shipley adviser.
The Investment Office