Coronavirus fears continue to dominate global markets, and headlines are driving sentiment. Overnight early in the session US equities had managed to claw back some losses. But proving just how sensitive markets are to the COVID-19 headlines, news that the state of California was monitoring 8,400 people for signs of the coronavirus saw sentiment reverse in quickly, followed by accelerating heavy selling into the close. Volatility was the name of the game, the VIX spiking to over 39. The S&P 500 then closed at session lows, falling 4.4%, marking the 6th straight day of losses for US equities and leaving the benchmark down 11% on the week so far. The speed of this correction has been extraordinary, the fall in the S&P 500 over the last 6 trading sessions has been the swiftest correction from a peak high on record.
This heavy selling has continued right across Asia, and equities are well offered across the board, even Chinese markets which have been until now relatively resilient succumbed to the pressure. The ASX 200 is on track to record the biggest 1 day drop in 2 years as sentiment remains fragile and uncertainty is rife. The virus is now present in every continent except Antarctica and pandemic, or not at this stage it doesn’t matter. What is clear is the outbreak is far from contained and continues to spread internationally, meaning the corresponding double whammy supply and demand shock that hits economic activity is significantly larger than most analysts have forecast and continues to mount. The eventual ramifications of the continued COVID-19 spread are impossible to predict with any level of credibility whilst contagion is ongoing and containment efforts have merely just begun in Europe and the US. In short, it is simply too early to forecast with any certainty the ultimate impact, particularly as the outbreak remains a moving target and a new information set is delivered every 24 hours.
This heightened uncertainty is one reason why markets remain headline driven and anxiety levels remain high, even after a week of heavy selling any rallies are continually being sold into. The other factor we touched upon in early February, as we were concerned with the level of complacency across risk assets. And again on Friday last week when we highlighted: At present we want to maintain optionality and hedge against these elevated tail risks. Namely, the impact of the coronavirus outbreak being far greater than is currently discounted across equity markets. This includes buying puts, gold, upside calls on the VIX and stock replacement strategies to limit losses in any correction. And given our view that equity markets are vulnerable to a near term correction, for more nimble traders we want to be tactically short into the weekend. Particularly given the spread of COVID-19 cases into countries with more transparent news reporting, meaning the headline risk has increased.
Valuations across the S&P 500, Nasdaq and ASX 200 were sitting well above historical averages, exacerbating downside moves as the spread of COVID-19 has catalysed an intense near term growth panic. The lack of concern corresponding to the impact on supply chains, demand and the potential for the COVID-19 outbreak to spread left the market playing catch up to the emerging realities as we now see contagion across the globe. The overextended optimistic sentiment saw the market ripe for a correction and completely disconnected from economic fundamentals. The corresponding unwind in this extended sentiment has then been stoked by ongoing uncertainty over the duration and economic impact of COVID-19 as globally cases have surged this week. Systematic selling, deleveraging and positioning across options markets has also added fuel to the fire. As heavy selling ensued options dealers have been forced to sell stocks or futures to remain market neutral, thus adding to the selling pressure. A more and more common phenomenon in our modernised financial markets. This dynamic can also work in the opposite way, but the unprecedented nature of the COVID-19 growth scare means it difficult to judge when.
So where do go from here?
The market will remain highly susceptible to negative headlines and sentiment will remain fragile until we have a clear picture of what containment looks like and what measures will eventually be implemented to limit the spread of the virus.
Although most equity indices look technically oversold at this stage, in the face of a potentially emergent global pandemic technicals go out the window. The VIX remains well above 30 and the VIX futures curve is in backwardation, an uncommon phenomenon meaning that investors expect more volatility in the near term. That is not to say there won’t be a bounce at some stage, even falling markets tend to fierce upside rallies. But we are sceptical of a bounce into the weekend given the emergent contagion in the US/Europe where news reporting is more transparent so potential for negative headlines a plenty, the release of China PMIs and margin calls exacerbating selling once more. As we said earlier this week, buying the dip is not such a sure thing against the current backdrop (unless its gold!). For markets to recover the onus will be on reduced COVID-19 transmission rates and a clear containment of the outbreak that spells a reduction in downside risks to economic activity. Volatility will remain until COVID-19 risks diminish.
When it comes to the ongoing spread of COVID-19, we leave that to the epidemiologists and medical professionals to comment. But if these experts in their field are uncertain about the final outcome, we can say with certainty that economists and forecasters should be just as uncertain. The potential for containment measures like shutdowns, border closures and quarantines to cascade through global supply chains well into Q2 is real and unquantifiable whilst the global contagion remains in its infancy. These unknowns relating to global supply chains pose increasing downside risks to economic growth over the coming quarters. This will then knock onto to corporate earnings via reduced revenues, increased costs and companies facing ongoing disruptions to inventory levels, logistics and labour supply. Again, analyst earnings revisions and forecasts are modelled on assumptions that are ill equipped to encapsulate the true scope of the disruptions that could entail should outbreak of COVID-19 escalate into a severe global pandemic with an effective shutdown of economic activity across the globe in order to contain the spread. If the virus continues to spread the market would have to discount these disruptions as a longer term reality and the subsequent uncertainties surrounding the hit to activity and longer term impacts like accelerated deglobalisation would see another wave of selling.
Although it has been an ugly week, to put things in perspective Aussie stocks are trading at levels last seen in October, Apple is trading at levels last seen in December and is still sitting on almost 60% of returns over the past 12 months. Things could get worse if the economic impact continues to mount, the jury is still out.
So, what we do know is this will result in a both supply and demand shock of magnitude unknown. We also know this will be followed by a coordinated bout of fiscal and monetary stimulus. However these tools may be largely ineffective for the sort of shock we are dealing with. The responses will also be slow to materialise, as exhibited by the BOKs unexpected decision to keep policy rates on hold yesterday. And a Fed that continue to push back against the market remaining reluctant to move.
Although monetary policy will not be an effective cure for a pandemic virus outbreak and the subsequent supply shock, the Fed will be forced to move in order to backstop confidence and ease financial conditions as the neutral rate of interest or r* falls meaning policy is too restrictive in real time. For a market addicted to easy monetary policy and conditioned to be reliant on the Fed put, rate cuts will be a necessary evil. The feedback loop from financial markets in the US to the real economy via the impact of share prices on CEO behaviour and consumer confidence alone guarantees this. With the consumer being a vital pillar of support to the US economy of late, the Fed cannot afford to be purely reactive. An incoming Powell pirouette will no doubt support sentiment, but if the COVID-19 spread continues, the Fed put will expire more quickly than in previous times. Rate cuts are no remedy for the supply side shock and the demand destruction that could come from a global pandemic.
Given the elevated tail risks of unknown magnitude we remain defensively positioned with a focus on capital preservation. We stick with our overweights in gold and US treasuries relative to equities.