Navigating the uncertainty

Last week we witnessed the fastest S&P 500 correction on record. It took only six days for the US benchmark to fall 10%, as the coronavirus extended its reach outside of Asia and the number of infections climbed. The recent plunge in the oil price to nearly USD30/bbl following the price war between Saudi Arabia and Russia further added to the market’s woes. Concerns that the collapse in oil prices could trigger a wave of defaults further rattled nervous investors, sending equity benchmarks and government bond yields even lower.

The depth and length of this outbreak, as well as how the virus will evolve are likely to be uncertainties which investors will have to continue to grapple with in the coming months. Growth forecasts have been slashed globally as the containment measures, together with the retrenchment in consumer confidence and business behaviour are expected to take a toll on economic activity. While the Institute of International Finance (IIF) has lowered its 2020 GDP forecasts for the US and China to 1.3% and 4.0% respectively, the wide range of analysts’ growth estimates reflects the challenge in assessing how long this epidemic will weigh on the global economy.

Yet, there are some mitigating factors.

We note that as the number of reported (infected) cases in China decline steadily, the Chinese and Asian equity markets have begun to outperform. See Fig. 1. This suggests that the developed markets could tread a similar path although this would hinge on the speed of their governments’ responses as well as their ability to impose “draconian” measures. The slower/weaker the response, the more drawn out the recovery, and the higher the likelihood of a recession in the US and Europe. The risks may be greatest in Europe where the banking system is more fragile and getting political agreement for fiscal support or draconian measures may take longer.

Fig. 1. Asian markets relative to the world¹

That said, a longer and wider dispersion of the outbreak would prompt more aggressive policy actions. Again, China offers a policy playbook. Since the outbreak, the Chinese authorities have boosted government bond issuance, lowered policy rates and provided cheap loans as well as fee subsidies to affected companies. This front-loaded monetary policy easing is expected to set the stage for more aggressive fiscal policy easing in the coming quarters, which should help to stabilise and lift growth. See Fig. 2.

Fig. 2. China’s credit and fiscal impulse leads global activity²

Across Asia, central banks in Malaysia, Philippines, Indonesia, Hong Kong and Thailand have cut rates. These policymakers together with their counterparts in Singapore, Korea and Japan have also announced stimulus measures. In the developed markets, although the Federal Reserve has cut rates by 50 basis points earlier in March, fiscal easing is likely to take centre stage in Europe and Japan, given the limited scope for monetary easing. At the same time, short term fiscal stimulus such as cash payments to low income households, tax breaks and loans support to small companies may be more effective than rate cuts at addressing the impact of the supply shock.

We are optimistic that the monetary and fiscal stimulus measures undertaken globally would boost growth later in the year. See Fig. 3. The rebound could potentially be rapid and strong if we get more clarity over the spread of the outbreak in the developed markets. Historically, falling bond yields and lower energy prices also tend to be supportive of economic activity and the markets.

Fig. 3. Global manufacturing PMI and monetary policy³

Over in the US, US high yield bond spreads have widened following the collapse in the oil price. While this could lead to a generalised credit crunch, a closer look reveals that most of the pain is concentrated among the energy issuers. With President Trump likely wanting to protect US oil independence and the US economy in an election year, a loan/financing package targeted at the sector cannot be ruled out.

We have de-risked our multi asset portfolios by lowering our equity exposure. We are also overweight duration in European fixed income. The VIX, which measures the stock market's expectation of volatility, has spiked above 40, signalling a short-term bottom for equity markets. While the current circumstances should provide a strong buying opportunity for risky assets, we believe that trying to time the market perfectly is a foolhardy exercise. As such, we prefer to focus on managing the risks in our portfolios amid an oversold technical backdrop and look to rebuild our equity exposure as markets rebound.

The lack of visibility over the oil price war is likely to remain an overhang on market sentiment in the short-term. The spread of the virus outside of China will also continue to weigh on demand for oil and oil prices. Nevertheless, the market has weathered through periods of low oil prices, such as in 2015, when oil prices slumped to near USD30/bbl on the back of growth fears. Our fixed income team notes that, compared to the US high yield bond market, the exposure to oil and gas issuers within the Asian USD high yield bond universe is relatively small. The exposure within our high yield bond portfolio consists mostly of companies that are state-owned/controlled, subsidiaries of blue-chip corporates or companies with no immediate financing needs. These are companies which we believe are likely to ride through a period of low oil prices.

The recent market corrections to date have made equity valuations more reasonable. Low volatility strategies are a viable solution for investors who want to take advantage of these cheaper equity valuations but prefer a more defensive stance as they are still worried about the market’s volatility. At the same time, the sharp swings in market sentiment in recent days are a testament to our value equity team’s disciplined focus on valuations. By relying on a valuation anchor, emotions are removed from the investment process, helping us to identify mispriced opportunities.