Mark Lister, 1 March 2020
Intended for clients of Craigs Investment Partners only
Global sharemarkets took a beating last week, on the back of mounting coronavirus fears. The S&P 500 in the US fell 11.5%, taking it into correction territory (down more than 10%) in what was the worst week since 2008. The local market held up better, although the NZX 50 still declined 6.7%. From an investment standpoint, it isn’t the virus itself that is the problem, but the flow-on effects in terms of disruption to business activity, economic growth and consumer confidence. Ultimately, this could have a significant effect on future corporate earnings, and it is these worries that are being reflected in today’s share prices. The level of uncertainty and fear of the unknown is also contributing to the volatility. Analysts have a reasonable idea how things will play out when an economy faces traditional challenges, but the outbreak and rapid spread of a new virus makes for a very unpredictable situation.
- We have held a slightly cautious bias to markets for some time now, with our tactical asset allocation suggesting higher than usual cash balances, healthy weightings to fixed income and a marginally underweight position in equities. Within equities, our portfolios are well diversified across the world with a focus on large, high-quality businesses. We are also tilted to defensive sectors and companies with sustainable, growing dividends that should provide a shock absorber during periods like this.
- Investors positioned in line with our philosophy and approach will be well served by their overall portfolio and should weather the storm better than most. While some equity markets have suffered heavy losses, our defensive approach gives us confidence our portfolios will be holding up better than the overall market, while our fixed income assets will have done their job in recent days, buffering the volatility and rising in value. For these reasons, we are not changing tack.
- Having said that, conservative investors who find themselves more exposed to growth assets than they are comfortable with (or relative to what their strategic asset allocation suggests) may want to consider rebalancing and moving closer to a neutral positioning. Despite the weakness of last week, many asset classes have still performed spectacularly in recent years.
- New investors should remain patient and wait for opportunities (of which some have emerged over the past several days), then maintain a disciplined approach to deploying funds in instalments. As always, stick to quality and ensure you are well diversified across asset classes, regions, sectors and companies.
- Investors in the ‘accumulation phase’ of their investment life cycle shouldn’t be bothered by what we have seen over the past week. Neither should anyone without the need to draw on their savings for 10 years or longer, including those in KiwiSaver growth funds (or securities). Owning shares in quality businesses that pay growing dividends remains an excellent strategy for wealth creation, not to mention inflation protection. While disconcerting, periods of volatility and weakness are simply the price we pay for superior long-term returns.
- Periods like this are uncomfortable for all investors (even those with many years of experience). However, we must remember that while asset classes like shares are excellent long-term investments, they can be very volatile over shorter periods. Since 1960, US shares have suffered seven bear markets and the US economy has experienced eight recessions. Despite this, the S&P 500 has delivered a return of 10% per annum since 1960 (including dividends) with a 100% track record of recovering from any downturn to trade at higher levels.
- If you do have any concerns or worries, it is an opportune time to get in touch with your adviser. Your adviser can ensure your current positioning fits your investment objectives, risk profile and investment time horizon, and they can help do any portfolio fine-tuning that is necessary.
How have the various markets performed through this volatility?
This time last week we wrote a report suggesting that markets were too complacent over the coronavirus outbreak, that a sell-off was looking increasingly likely and that investors would be wise to apply some caution over the near-term. However, we didn’t expect the weakness to emerge quite so quickly or with such vigour.
The chart below illustrates the declines we have seen in recent days. Equity market falls are relative to 2020 highs, while other changes are all based on the year-to-date moves.
Equity markets and risk assets have been heavily sold off across the board. The S&P 500 in the US is 12.8% below its previous high (which only occurred on February 19) while the local NZX 50 has held up better, with a fall of 6.7% from its peak last Friday.
Commodities have weakened, with oil down 24.9% and whole milk powder down 4.3% since the beginning of the year. Meanwhile, haven assets have performed strongly. Gold has continued to rise, while steep declines in interest rates have seen bonds rally.
The NZ dollar is down 5.0% on a trade weighted basis and 7.3% lower against the US dollar (which will offset the decline in dairy prices).
What’s caused the sudden bout of panic?
Markets have reacted negatively to the news of coronavirus cases emerging outside of China. Up until this time last week, it was very much a Chinese issue, with very limited examples of the virus spreading elsewhere.
Furthermore, due to the strong efforts of the authorities, China was getting the virus under control. The number of new cases per day had peaked and was starting to decline, so the total number of cases was flattening off.
However, upon news of the virus reaching South Korea, Iran and Italy, markets began to price in a much greater likelihood of a global pandemic. This would mean the disruption we have seen in China during recent weeks becomes the norm in many other countries, reducing economic activity and taking a decent chunk out of economic growth and corporate earnings.
The virus has proved to spread much more quickly than SARS did, although it has a much lower fatality rate (3.4% compared with almost 10%). Some analysts now see the H1N1 episode of 2009/10 as a better comparison than SARS.
A decade ago, H1N1 infected a billion people globally and 60.8 million in the US, according to the World Health Organisation (WHO). However, the fatality rate was very benign, with just 0.04% of those who were infected estimated to have died from the virus.
If coronavirus spreads to a similar number of people, we could see 30 million deaths worldwide and two million in the US. That may be somewhat of a worst-case scenario, but these are the types of confronting possibilities that markets are grappling with.
Has the impact of coronavirus showed up in economic indicators yet?
It’s starting to, and we should expect the next few months of economic releases to look weak as further information comes to light. So far, surveys are starting to show the extent of the disruption, and numerous companies around the world have also noted the impact it is having on their businesses.
Last week’s ANZ Business Outlook survey for February reflected weaker sentiment across the board. The headline confidence index fell from -13.2 to -19.4, well below average although not nearly as bad as that which prevailed through the middle of last year. The Own Activity index, which correlates better with future economic growth, declined by a similar degree from 17.2 to 12.0.
Importantly, ANZ noted that about a third of the responses came after the coronavirus outbreak hit the headlines, and that these responses were more negative. This suggests that the official survey results underestimate just how much business sentiment has fallen in recent times. In terms of the various industry sectors, manufacturing and agriculture were the most cautious, while construction was the most optimistic.
The previous week saw monthly flash PMIs released for several major economies. As one of the first measures of February activity, these provided a good steer on just how much disruption coronavirus is causing.
The answers weren't encouraging. The Japanese PMI suffered its biggest fall in almost six years, raising the prospect of a technical recession in the world's third largest economy.
The US measure was also well below expectations, pointing to the first contraction in output since October 2013. A much weaker services sector was a notable feature of the survey, while new export orders also declined.
Unsurprisingly, Australia looks set be caught in the crossfire too, with its PMI falling to the lowest in at least three years as respondents cited falling demand, poor weather (including the bushfires) and the virus as key worries.
Factory activity in China contracted at the fastest pace in history during February, with China's official Purchasing Managers’ Index (PMI) declining to a record low of 35.7, compared with 50.0 in January. That's even worse than the 38.8 that China posted back in November 2008, in the depths of the financial crisis, and it’s certainly well below the breakeven 50-level. The non-manufacturing PMI wasn’t much better, dropping from 54.1 last month to 29.6 in February, the lowest since November 2011.
Is this likely to get even worse from here?
There have been 19 corrections (falls of more than 10%) since 1979 for the S&P 500, as detailed in the table below. On just four occasions, these have developed into bear markets (falls of more than 20%).
The other 14 corrections remained just that, corrections (although the fall in 1990/91 went very close to being officially categorised as a bear market, as did the decline in late 2018). In simple terms, we could deduce that four out of five corrections do not turn into bear markets.
Usually reliable economic markers (such as the yield curve, unemployment rate and credit markets) have not been providing the signs that usually point to a looming major economic difficulty, outside of the coronavirus-induced disruption. In fact, many of these economic indicators were improving before the virus erupted onto the scene.
Monetary policy remains highly accommodative and will likely become even more so. Severe and sustained economic downturns are rare when central banks are providing such support.
As unnerving as the current volatility is, we don’t expect it to turn into another decline anywhere near the magnitude of 2008/09. Markets could suffer further downside from here and they will almost certainly remain volatile, but our best guess is that worst of the sell-off is behind us.
How might central banks or governments react?
Markets see a high chance of central banks responding to the uncertainty and they have moved quickly to price in rate cuts in numerous places, including the US and New Zealand.
The chart below illustrates historic policy rates for some of the major central banks, as well as the expected path over the next 12 months based on current market pricing.
As of Saturday, market pricing implied at least two rate cuts in both Australia and New Zealand over the coming year, and almost four rate cuts in the US (assuming each rate is a 0.25% move).
The next Reserve Bank of Australia decision is on Tuesday, the Fed is scheduled to meet on March 17 and 18, while the next Official Cash Rate decision from the Reserve Bank of New Zealand takes place on March 25.
A March rate cut from the Fed is seen as a certainty, while pricing suggests an 88% and 72% chance (respectively) of cuts in Australia and New Zealand at those upcoming meetings.
Fed Chair Jerome Powell said on Friday that the virus “poses evolving risks to economic activity”. He noted that the US economy remained strong, but that the Fed was monitoring the situation and would “use our tools and act as appropriate to support the economy”.
How should investors approach such volatile conditions?
Our key messages to investors can be found on the first page of this report. We chose to highlight these first up, rather than at the end given how to approach this extreme volatility is the most pertinent question of all.
Looking at the large intraday swings that have occurred at times in recent days, it is also likely that the increasing prevalence of computer trading has played a role. A larger proportion of the market is made up of algorithm-based trading strategies these days, and this can accentuate the moves during volatile periods.
We would also remind investors that markets had been exceptionally strong in the lead up to last week. Numerous markets were at record highs, and 2019 was one of the strongest years seen in some time.
In fact, despite the hefty sell-off equities have experienced over the past several trading days, the S&P 500 is still 6.1% higher than it was 12 months ago (more if dividends are included, and more still if the 8.2% decline in the NZ dollar against the US dollar is considered). The NZX 50 is still more than 20% above the levels of a year ago.
It’s impossible to say how long this volatility persists, or how much further markets could decline. We might be in for a prolonged period of rocky markets (weeks or even months) as investors grapple with the impacts of coronavirus, or we could see a rebound relatively quickly if the virus spreads less rapidly and with less impact than feared.
There is no silver bullet to protect investors from these periods of weakness and volatility, although for many the turmoil needn’t trigger a change of approach. If you have worked with your adviser from the beginning to ensure your asset allocation is appropriate, you will already be in a strong position to weather any storm.