Equities: The case for further caution
Despite the massive declines in markets, we are wary on the outlook for risk assets like global equities, given the large uncertainty over the economic impact of COVID-19 and the efficacy of the response from policymakers.
I hope that everyone’s families, friends and businesses are weathering these difficult times well. Health is such a precious thing and it is all too easy for us to take it for granted, so in that respect the coronavirus is a jolt for us all as individuals as well as for global economies and markets.
As central bankers and governments unveil increasingly powerful measures to mitigate the economic and financial impact of the coronavirus outbreak, many investors are asking: is now the time to buy the dip in equities?
We believe the answer is “no” – for now – and are increasing our cautious tactical stance on stocks.
Earnings and uncertainty
We are fighting several somewhat-related crises at the same time. First, we have the impact of the coronavirus on the economy and on corporate earnings.
Under our base-case view, where there is no effective medicine or vaccine and summer weather doesn’t end the pandemic, we believe the social-distancing measures will need to be continued for at least six months and potentially much longer.
The consensus is for a fairly quick recovery (a few weeks) after the initial economic collapse. We are sceptical this will be possible based on our careful monitoring of countries like China, South Korea and Singapore. Moreover, we believe the numbers of those people affected by the virus in the US and the UK are unfortunately going to increase further before they decline, with social isolation in the US only just starting.
Under this scenario, we expect a decline in company earnings of about 40%. We think markets are not ready for this kind of earnings adjustment, hence stock markets could drop even further once they face the reality of this earnings outlook.
As a result, we expect to see worse news over the coming weeks and months on the economic toll exacted by the outbreak; this could be in the form, for example, of a significant rise in unemployment and company defaults. Once we get these kinds of headlines, it is likely markets start to worry about the implications of darker scenarios for the sustainability of the euro area and the health of some financial institutions.
Second, we see a lack of dollar liquidity; this creates echoes of the 2008 crisis as two US money-market funds had to take injections from their sponsors last week in order to maintain regulatory minimum levels of liquidity.
Some measures of short-dated liquidity stress are improving from very weak levels and the dollar has stopped rising quite so aggressively (although the pound is weaker at the time of writing). In addition, government bond yields have fallen significantly since Thursday last week. This is taking some pressure off credit markets. However, fund outflows are a common concern across all asset classes, and it’s very hard to know which leveraged funds or products are hitting margin calls and how much forced selling this will precipitate. This unknown is understandably making investors nervous and encouraging cash hoarding where possible.
Meanwhile, even though policymakers globally are prepared to go all in, markets are still struggling to see how their efforts will improve market liquidity and prop up the real economy. I believe the situation is somewhat comparable with 2008, when policymakers did whatever they could, but real economic evidence of their actions taking effect was necessary for markets to turn decisively higher in March 2009.
Arguably, this time it is more complicated for central banks to do whatever it takes as it is easier to address a credit crisis than one in which people fear for their health. This is not a liquidity crisis that may become a solvency crisis; this is simply a solvency crisis. Firms fail when they have no revenue.
Third, we have a collapse in the oil price due to the bust up between Russia and Saudi Arabia regarding supply combined with plunging demand in the weak economy. Though a low oil price always has winners and losers, it aggravates credit risks in the US as energy companies are an important part of the credit universe.
Our next move
Taken together, these points make us more wary than the consensus view regarding the near-term outlook for global equities, on which we have recently taken a tactical negative stance.
Over the medium term, this crisis will create fantastic buying opportunities, provided there is not too much systemic damage. We expect to turn positive either in the wake of much deeper market declines, or when we receive more clarity on the path of the outbreak, or if the consensus catches up with our earnings and economic views.