Equity Update: Sentiment Fades
Summary: The stimulus fuelled mania that has driven stocks higher over the past week, with investors ignoring the mounting demand destruction in China, company warnings and threat of supply side shocks, is subsiding into the weekend. Equity markets across Asia are in the red and US equity futures are also sliding.
Ten-year Treasury yields have fallen below 1.5% for the first time since September, and gold continues to strengthen as investors look for safe havens amidst the uncertainties surrounding the hit to economic growth from the virus outbreak. The Aussie dollar fell below 0.66 for the first time since March 2009 as risk sentiment continues to fade, the USD strengthens and traders weigh the Australian economy as one of the most China dependant economies globally. And this is just the first hurdle for the currency, the domestic outlook and prospect of continued easing from the RBA presents an additional drag. As we said previously, as market pricing for continued easing ramps up the AUD will remain under pressure, despite a lot of bad news already reflected in the currency already, market positioning dictates it can fall further.
Aussie shares have retreated, after closing at a fresh record high on Thursday, as investors look to dial back on risk going into the weekend. A rise in coronavirus cases outside of China is denting sentiment as Iran, Japan and South Korea confirm new cases, sparking fresh fears that the outbreak is far from contained within China. Testing the resolve of equity markets, that have been resilient to date.
In our view, non-linear supply side effects like production bottlenecks are the real wildcard in terms of further forecast downgrades to growth, earnings and longer term disruptions. There is the added issue of a lack of reliable data with which to generate robust forecasts which adds to the uncertainty. Real time indicators of Chinese activity like traffic congestion, property sales and coal consumption, continue to point to a country still very much on lock down. Whilst the narrative from China is attempting to maintain the country is through the worst, reports that lockdowns are being further implemented in Beijing and businesses in Hubei have been told not to resume work before March 10 paint a different picture. As is often the case the clearest indicators are what authorities in China do, not what they say.
Extended shutdowns and broader quarantines lends the potential for the recovery and ripple effects to be much more drawn out than is currently anticipated. Notwithstanding the supply disruptions and production bottlenecks that ensue. The impact on company earnings is therefore likely to be larger than is currently being accounted for, putting the previously forecast earnings recovery in jeopardy. Warnings from a host of companies like Apple and Alibaba are warnings that investors should heed as the impact unfolds and uncertainty over the severity and duration of the outbreak remains.
As always, risk builds slowly and happens instantaneously. And investors have chosen to prioritise an impending cocktail of dual monetary and fiscal stimulus measures as a cure all pushing markets to fresh record highs. But over the coming weeks, there is increased risk of continued downgrades to growth and earnings, and hard data catching down to the realities of the present disruptions to economic activity, travel and supply chains which could see volatility pick up in the short term. Particularly if the outbreak continues its contagion outside of China. With equities having rallied hard since the beginning of 2019, valuations are stretched at present. The sharp upwards move along with increasingly stretched valuations and an incoming hit to earnings leaves the market vulnerable to a near term correction. We do not want to advocate panic, but stress that a more rational approach does not underestimate the impact on economic growth and earnings as the story evolves.
Amidst these lingering concerns, the USD remains well bid. The USD continues to outperform on the FX stage, against consensus expectations that the dollar would weaken this year. The dollar index is closing in the 100 level, a breach of which would enforce an ongoing capitulation from those who were braced for a fall in the dollar this year. With this USD strength comes an additional hit to growth as the strong USD tightens financial conditions globally, particularly in offshore funding markets. The strong dollar hinders reflationary pulses and curtails green shoots therefore cementing the path for weaker economic growth, adding to the haven bid for long term bond yields.
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.
But contextualizing this risk of a near term correction with a longer term outlook, the impact will not permanently dent global growth (at this stage) and the world is not falling apart. Market sentiment may be infected by the coronavirus outbreak, but maintaining the discipline to stick with your long term strategy will be the cure.
As we have said before, in the current investing paradigm, liquidity injections and further interest rate cuts are likely to be a feature of the response mechanism from central banks. So, for as long as investors feel like central banks have their back and policy rates remain low, the longer term tailwinds for equities remain. Rate hikes and the ”normalisation” of monetary policy comes with an increasingly higher bar as central banks reaction functions have become more asymmetric, feeding an expectation that rates will remain low for an extended period. And whilst inflation is low, and recession is not imminent, lower interest rates feed into valuation models, justifying higher multiples, and fuelling asset price inflation. Another feature of this regime is the re-calibration of long term interest rate expectations at current levels which draws capital up the risk spectrum. A powerful driver of upside momentum. In the present environment, it is hard to see that changing.