Equity markets have had a very challenging few days, however other diversifying assets have performed positively. As the asset class table below shows, the recent drawdowns have been broad-based across both domestic and international equities. Safe haven assets like U.S.Treasuries have seen increased demand, driving values up and the 10-Year yield to an all-time low.
When equity markets fall so aggressively in such a short period of time, and when headlines feel dire, many feel tempted to take action. Given these feelings some may be experiencing, we thought it might be helpful to share a few factors that we believe are driving markets, some context around the recent moves, and what to consider before making any changes to an investment strategy:
Coronavirus (COVID-19) concerns are growing. The flu-like virus has spread globally, reaching parts of the Middle East, South Korea, Japan, and Italy. The market’s initial belief that this would be contained to China no longer holds, and cross-asset price action suggests a material disruption to supply chains and consumer activity will create a negative, global economic growth impact. We expect this will not have a particularly significant influence on the U.S. economy, and therefore as the virus runs its natural course, a V-shaped equity recovery is likely.
U.S. Presidential politics are coming to bear on markets. Virtually 100% of the “explanation” for the recent weakness focuses on the Coronavirus, but Senator Bernie Sanders has been rising in the polls and currently is the favorite to win the Democratic nomination (about a 60% chance for Sanders versus a 20% chance for any other individual candidate, per Bloomberg LP PredictIt). Prior to Saturday’s Nevada primary, Sanders’ broad-sweeping, democratic-socialist policies had not yet been widely priced into the market - it is difficult to determine how much of this week’s equity market decline is attributable to his ascent.
Despite the sharp drawdown in the S&P 500 from February 21th to the 25th, the market has only fallen to a price level that we saw in early December of last year. Year-to-date, the S&P 500 Index is down just 2.9% as of Tuesday’s close -- or simply back to just below where we started the year. Importantly, this pullback brought P/E ratios back to a bit closer to fair value, as stocks had gotten overvalued; this is a refreshing pause that may require a bit more rest.
Source: S&P 500 Index (SPX) from Bloomberg L.P.
Since 1928, past episodes of similar market performance (S&P 500 down 6-9% over a 4-trading day period) suggest a strong bias to a short-term sharp recovery: median S&P 500 performance over the following week is +1.6% (positive 78% of the time) and median S&P 500 performance over the following 3 months is +7.7% (positive 89% of the time).
Historically, sharp selloffs like we have experienced are typically the market’s reaction to a large amount of new uncertainty. Once more information becomes known, the market is able to price in a more narrow range of likely outcomes that have historically been slightly more positive than the initial “panic reaction”.
- We think it is critically important that the Chinese equity market (SHSZ300) has outperformed the S&P 500 in February and is positive thus far for this month - all despite China being the epicenter of the virus. This implies that the Coronavirus’ impact may be nearly fully “priced into” the market from when it all started, now about a month after the virus became public knowledge.
1 Week Return
Return Since Outbreak
U.S. 10 year Yield (bp)
Source: Index data from Bloomberg L. P. & Horizon Investments | As of 2/25/20 close | “Return Since Outbreak” start date is 1/17/2020 Table 1: Returns of headline broad market segments
What are we watching going forward?
Shorter term, the rate of new infections globally, as well as the efficacy of containment efforts both in China and elsewhere, are key to determining the impacts on economic growth and investor risk sentiment of the coronavirus from here.
Intermediate term, the Federal Reserve and other central banks are on high alert. We believe the Fed will cut rates if sentiment deteriorates and equities go lower -- just like they did last summer and markedly different from their actions in Q4 of 2018.
Longer term, the impact of last night’s Democratic debate heading into the South Carolina primary and Super Tuesday is the thing to watch on the political front. The moderate portion of the Democratic party needs to coalesce around one moderate candidate or the uber-left Sanders is very likely to be the nominee. If we see candidates cancelling fundraisers or appearances in the coming days, that would be a signal that the Democratic party has started the winnowing process. It will be interesting to see how financial markets react when the Democratic candidate becomes more clear, and after that to analyze the perception of how that candidate might stack up in the likelihood of unseating our incumbent President.
- For now, we reaffirm our position of being neither bullish nor bearish short-term, but rather, cautiously optimistic that the U.S. economy remains solid, and that global economies are in the midst of a slow recovery, albeit now further-challenged.
While we nor anyone else can predict the future, as we have discussed in the past, volatility is not irregular in markets and oftimes lack of clarity is the culprit in creating the tumult. Unexpected events can happen, and it is important that investors be positioned in such a way as-to be comfortable that their risk/reward parameters are being met during these times of uncertainty. Should you have any additional questions or comments, please reach out to us to discuss.