FEARS AROUND CORONAVIRUS (COVID-19) SPILLS INTO FINANCIAL MARKETS
The world entered 2020 with an economic outlook that was quietly confident that a cyclical improvement was in its infancy. This was based on several generally positive factors, including that it is an election year in the United States (US) and that several central banks were lowering interest rates. This created a very conducive environment for a generalised global upswing in economic activity. Then news broke of the Coronavirus.
When China originally announced the outbreak of the virus and the measures they were taking to curb its spread, the world was impressed. The mortality rate and numbers were quite small compared to previous cases of SARS, MERS and swine flu, and China’s official response was extremely firm. Several cities were quarantined in their entirety and workers were ordered not to return from Lunar New Year holidays, all in an attempt to prevent the spreading of the virus. Markets applauded and went to new record highs.
As the rate of new infections in China declined, it seemed that the virus would wear itself out by the summer and fears receded. Then the virus suddenly appeared outside China with new cases and deaths being reported in countries such as Iran, Italy, South Korea, Japan, Germany, France, Singapore, Spain, Australia and the US. Suddenly the possibility of a global pandemic and its knock-on effects on economic growth, coincided with equity markets sitting at record highs. A fall-out was inevitable.
Global markets sold off aggressively during the last week of February with most equity markets dropping around 10% for the week, leaving the year-to-date numbers for 2020 roughly the same, erasing the gains of January and early February. US treasury yields plummeted to all-time lows as investors raced for safe haven assets. Interestingly, the one safe haven asset that absolutely disappointed, was gold. It lost 7% during this volatile week. Oil, energy and consumer-facing stocks were pummelled as growth mark-downs filtered through the system. Emerging market stocks and currencies also didn’t escape the risk-off sword and got sold off.
The size of this move isn’t surprising at all within the history of financial markets. A 12% drawdown from a record high is considered healthy, and a 10% drop in a week is considered measured, with no extreme-volatility market trip-switches even activated during this period. The only reason this feels so intense, is because we haven’t experienced normal, meaningful, cyclical retracements during the past decade, because central banks have flooded markets with free cash.
Now you may ask, “Won’t central banks do this again?” Yes, they will. The only problem is that the marginal efficacy of monetary stimulation has declined over time. In addition, no amount of monetary or fiscal stimulation can solve a virological and logistical problem. As trade and travel bans are implemented, the world will grind to a standstill as supply chains get disrupted. Yes, they’ll start up again, but there’s no doubt that economic growth has been dealt a severe body blow.
CITADEL’S MARKET VIEW
China’s explicit aim to have that country’s 2010 per capita gross domestic product (GDP) doubled by the end of this year is under significant threat from the far reaching impact of the COVID-19 virus outbreak, which will in all likelihood push Chinese economic growth into deeply negative territory in the first quarter of 2020. We don’t currently expect a sharp V-shaped recovery in China, mainly as a result of China’s small and medium size companies (which collectively account for about 60% of overall economic activity) still only functioning at less than 50% of normal capacity.
As a result, authorities have announced significant stimulatory measures over the past couple of weeks to boost the economy. These range from monetary stimulus (via reduced interest rates, effective support of the financial system via significant liquidity injections, extensions on loan repayments, etc.) and fiscal stimulus (targeted tax and VAT reductions, delaying of tax payments and increased government spending, etc.) to more general support measures, which include subsidies to farmers, and delays in the implementation of new vehicle emissions standards.
Although this comprehensive range of support measures is likely to support an economic recovery going forward, there is a significant chance that China would not achieve their +/- 6% economic growth target for 2020.
Although we could not have predicted the Coronavirus, Citadel has been raising caution since the latter half of 2019 that markets are priced for a perfect world despite many headwinds. Our outlook for the year cited prudence due to the elevated valuation levels of many asset classes and markets. We reduced our houseview allocations of risky assets and increased exposure to alternative strategies in our multi-asset solutions. This should put us in a good position should markets continue to react to the spread of the Coronavirus.
When it comes to South Africa, we’ve been concerned about the deterioration of the fiscal metrics for the past few years and have reduced our holdings in bonds in line with a sub-investment grade, despite Moody’s not reacting to whatever is being thrown at them. The twin-deficit, along with SA’s politically-constrained growth potential, has kept us negative on the rand. We expect the currency to show flow-induced deterioration following a downgrade. A new equilibrium will be found soon after as new speculative money gets attracted by some of the highest yields in the world. Volatility will thus remain with us in South Africa, long after the world has finally bid farewell to COVID-19.
To indicate this, the first and second graphs show global equities as represented by the MSCI All Country World Index and the JSE All Share Index. Both these show that within the context of the last 12 months, the current sell-off is sizable, but not at all outside character for risk-markets. The third graph shows the rand over the last five years and that even at R15.80 it is not yet oversold against its long-term dynamics. A downgrade by Moody’s at the end of March should take the rand north of R17.00 followed by some consolidation. Should a downgrade not happen in March, the rand will mark time in tune with global developments, before the next ratings guillotine-moment in November. We believe Moody’s is just postponing the obvious. The last graph highlights how a decline in the All Share Price Index relative to earnings restores fair valuation in a market. Granted, earnings numbers are historic, and those numbers still need to be adjusted to the virus-induced slowdown, which explains the market’s current unease.
GLOBAL EQUITIES AS REPRESENTED BY THE MSCI ALL COUNTRY WORLD INDEX
GLOBAL EQUITIES AS REPRESENTED BY THE JSE ALL SHARE INDEX
RAND VOLATILITY OVER THE LAST FIVE YEARS
ALL SHARE PRICE INDEX RELATIVE TO EARNINGS
Overall these market moves are well within normal risk bounds for their respective asset classes. Markets often react unpredictably, it’s like the old saying goes: “It doesn’t matter…till it does”. This scare in the markets removed much froth and returned risk markets to much fairer valuations. What we will monitor closely is whether the current disruption will merely hamper economic growth in the short term, or whether it will totally trip up the global economy into a full-blown recession. Currently there’s little foundation for deducing the latter.
One of the key pillars of our investment philosophy is that the future is uncertain and impossible to predict. While we cannot forecast the future, we build solutions that are able to cope effectively with uncertainty. When unforeseen events like the Coronavirus arise, our portfolios are built to absorb these uncertainties and stay the course.
We want to remind you that sticking to your long-term investment roadmap is more important than ever. However scary this volatility may seem, it is a natural part of markets and is the exact foundation of long-term opportunities.
Written by Citadel Chief Investment Officer, George Herman