In this update, JH&P’s Head of Investments, James Beck, looks at the factors driving extreme market movements and asks whether we are witnessing a short sharp shock or the start of a prolonged slowdown.
Markets deteriorated significantly at the start of this week, less than a month afer reaching new highs. This is despite signs that the virus is plateauing in China, where the People’s Party quarantined large swathes of the country.
The catalyst for the movements of the last two weeks was a surge in the number of cases outside China, particularly South Korea, Iran and Italy. The falls in equity markets have been particularly sharp, with declines of more than 10% in most markets accompanied by a significant spike in volatility; the speed of the 10% retracement in February was unparalleled outside of the great depression of the 1930s. The exception to these falls is China, where the CSI 300 index touched a two-year high on Thursday 5th March 2020.
These already sharp moves have been further compounded by a disagreement between Russia and Saudi Arabia over OPEC production cuts that has seen a 26% fall in the price of oil on Monday 9th March with an inevitable indiscriminate impact on equity market sentiment.
With equity markets in retreat, investors have been seeking sanctuary in the traditional haven assets of UK & US government bonds and Gold. The yield on the US ten-year government bond has more than halved from 1.5% to 0.5%, providing good returns while gold has risen 10%. These havens have provided security and protection in a way that other fixed income instruments such as corporate bonds or high-yield bonds have not.
We absolutely expect asset markets, and equities, to remain extremely volatile in the coming weeks as investors grapple with the near-term human impact and the potential longer-term economic implications of Covid-19. Daily market moves are also increasingly driven by quantitative and algorithmically driven strategies that feed off market momentum rather than considering business fundamentals. The combination of forced deleveraging from hedge funds and the increasing influence of momentum strategies means that equity markets will likely remain under short-term pressure and the intraday swings will look extreme.
It is clearly impossible to forecast the economic and market impact of Covid-19 with any accuracy. However, the world has experienced viral outbreaks in the past which we consider to be helpful in understanding how the duration of the pandemic may evolve and it is this that we are using to help formulate our strategy in answering two key questions:
- How long will it last?
- How bad will it get?
Based on the experience of the two major pandemics of the 21st century, SARS in 2003 and H1N1 in 2009/10, the likely duration of the outbreak is six months with a peak in the summer. The peak in the Northern hemisphere should be expected in May with an abatement thereafter. The H1N1 swine flu virus in 2009 infected between 10% and 20% of the global population. The initial estimation of the fatality rate for swine flu was greater than 3% (like the current situation for Covid-19), however, over time it became clear that there were many undiagnosed and reported cases and the World Health Organisation’s final estimated mortality rate was 0.02%.
It will categorically be different this time, yet the evidence from the Diamond Princess cruise ship suggests that the current estimations of a 3% fatality rate may be too high; 20% of the passengers aboard the ship were infected and, of those 705-infected people, six have died. All those who sadly died were over the age of 70. From a human perspective it is not unreasonable to think that the number of reported cases is materially understated and, as a result, the potential dangers to human life may be less than the current statistics imply.
Whilst the virus will undoubtedly infect a great many more, there are also signs it can be at least partially contained. The week to the 4th March saw the number of countries reporting cases rise from 50 to 85, but China reported only 42 new cases outside of Hubei. On 4th February China reported an additional 3,887 cases and on 4th March the number was 139, suggesting that the quarantine had been a success. Whilst data released by China will understandably be treated with suspicion, both Hong Kong and Singapore have been successful thus far in stemming the outbreak. The Chinese response is difficult to replicate in western democracies and the measures taken will differ from country to country. However, the announcement from Italy that they will quarantine 16 million people in Lombardy and neighbouring regions suggests that some will at least try to mimic the Chinese approach. Companies too are responding to the threat of disruption. It is the response from the healthy segments of society and governments that has materially differed from previous outbreaks.
From an investment perspective, it is this response that represents the greatest risk. The original concern was that the shutdown of factories and quarantining of Hubei would cause a supply-side issue given the importance of China in the integrated global supply chain. As the virus has spread, eliciting a containment response from the authorities and businesses, the economic impact has moved from a disruption of supply to a fall in demand as restriction of free movement and declining confidence has had an impact on consumer and corporate behaviour. This is why we consider the length and significance of the containment of particular importance. The longer that demand is weak, the bigger the risk that this morphs from being a short term economic shock, with the prospect for a rapid recovery in the second half of the year, to a prolonged slowdown.
Governments and institutions have recognised these risks and are already taking action to try and support the economy. Whilst growth forecasts for 2020 will inevitably come down, with the OECD already having reduced its global growth forecast from 2.9% to 2.4% and likely to do so again, the policy response is putting in place measures to mitigate the slowdown and to support a recovery once the virus passes its peak.
Though monetary policy cannot cure Covid-19, the US Federal Reserve last week cut interest rates by 0.5% to help stabilise financial markets and improve financial conditions by lowering the cost of borrowing. Rates have also been lowered in China, Australia, Canada and Indonesia and we would expect to see other central banks follow suit. The longer the situation persists the more likely we are to see the return of unconventional measures such as liquidity injections and quantitative easing. We are also increasingly seeing more targeted measures to help companies and individuals manage the cash crunch. The World Bank and International Monetary Fund have pledged $12bn and $50bn respectively to combat Covid-19, US Congress approved an $8bn emergency package, Italy has set aside $4bn as has Singapore, whilst Hong Kong issued HK$10,000 directly to each citizen.
Supporting the economy
As the disruption persists, more fiscal stimulus will be forthcoming. Rishi Sunak will present the UK budget on 11th March at which he has undertaken to provide whatever support the NHS needs, and governments are working with the financial sector to provide aid to small and mid-sized businesses through the shutdown. There is a recognition of the challenges that these companies face from disrupted cash flows and a temporary inability to access credit. Banks, too, recognise the risk and there is an understanding that measures need to be taken to stop a fall in demand becoming a solvency issue. The lessons learned by governments and banks in the financial crisis will be valuable in this period of upheaval.
Our central scenario is that the public health impact will peak by the early summer, like both previous viral pandemics and the experience in China. There will be a sharp slowdown in the global economy and we will see most companies forced to adjust down their earnings. Analysts and share prices have already begun to adjust to a more prolonged period of weakness. However, we recognise that the risks have risen and that our central scenario may prove too optimistic. We have therefore been reviewing our holdings and have taken decisions to reduce exposures to any businesses that are particularly exposed to a prolonged cyclical slowdown or where we have any questions regarding the balance sheet. In truth, our investment philosophy means that we eschew companies with leveraged or stretched balance sheets and those that are deeply cyclical.
We manage diversified portfolios, both in terms of asset classes and the factors that may influence the near and the longer-term drivers of returns. We do this specifically to mitigate the risks that any single event can impact the entire portfolio. We have a longer-term time horizon for the very reason that markets can be reactive to short-term news and swings in sentiment. The funds we own typically favour companies that have structural drivers of growth, which means that they tend to be less sensitive to the economic cycle and have the balance sheet strength to withstand periods of operational challenge.
However, being long-term investors does not mean that we cannot be quick to change direction as the situation demands. We focus on liquidity in all our investments and we are ready and able to adapt quickly, should the situation deteriorate. The team will continue to meet regularly and remain vigilant as the virus progresses, with a view not only to protecting portfolios but also to taking advantage of any long-term opportunities that the short-term moves in markets may present.
By James Beck
Updated on 10th March 2020
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