Coronavirus drives fastest bear market ever

CIO Alert published at 12 March 2020, 10:04PM UTC

What has happened?

Markets sold off on Thursday as investors priced in the view that the intensity and duration of COVID-19’s economic impact will be worse than expected, but is also still not fully known. This is the result of several factors:

US President Donald Trump announced a 30-day travel ban on citizens from 26 European countries. Italy's government ordered shops to be closed until 25 March, excluding grocery stores and pharmacies. The UK also moved from the containment to delay phase of managing the outbreak. For many Americans, it was notable that the actor Tom Hanks tested positive for the virus, and the National Basketball Association canceled the rest of its season. As the economic impact widens, investors' hopes for "enough" government stimulus are growing. Yet those hopes are turning into a realization that it is apparently a lot harder to provide economic support to people and businesses in Western democracies than it is in China.

On Thursday there were signs of panic and indiscriminate selling, particularly after the European Central Bank's press conference. The dollar rallied, which appeared to reflect a squeeze in dollar funding markets rather than fundamentals. Thirty-year US Treasury yields rose even though equities were falling, potentially signaling that investors were selling their most liquid assets to meet redemptions. Credit spreads widened in illiquid trading conditions. Reflecting these market developments, in its statement announcing the new repo operations, the New York Fed said it was acting to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak. The extension of its reserve management purchases across the curve effectively acknowledges that the Fed has resumed quantitative easing (QE). Over time the importance of QE in helping a recovery take hold without a rapid rise in bond yields will matter a great deal to investors, but more likely only after they understand the scope of fiscal stimulus being deployed.

In Europe, risk premiums on European government bonds continued to rise sharply after the ECB unveiled policy measures that failed to impress markets. The announcement reflected a shift toward private sector assets and made no reference to possibly removing or raising the issuer limit of 33% for public sector bond purchases. In light of growing demands for fiscal action to cover coronavirus-related economic damage, a lack of additional ECB government bond buying is a negative for the asset class, in our view. Spreads on French bonds (62bps over German Bunds) and bonds of most other Eurozone countries reached their highest levels in three years. Outflows from ETFs that failed to find a firm bid took European high yield and emerging market bond funds down over 10% on the day. While these moves appear detached from credit fundamentals, it may yet be too early to expect the technical selling pressures to abate.

Will this get worse before it gets better?

We see encouraging signs from China, Singapore, Hong Kong, and Korea that the outbreak can be contained with time and action. Italy has now imposed widespread restrictions to bring the outbreak under control, but given the lags in virus incubation and diagnosis, it is likely to be at least two weeks before we can assess whether such efforts are proving effective. Thus, we expect public fear and economic disruption to continue to rise through the end of March, as the virus continues to spread in Europe and the US.

Meanwhile, measures announced so far in the US, and elsewhere in Europe, are less restrictive. We don't yet know how restrictive containment must be for it to be effective, but given the certainty that confirmed coronavirus cases will rise over the near term, investors want to see the numbers falling before they can start to quantify the full economic impact of the crisis and the government stimulus designed to restart economic growth.

How far could the market decline go? What could drive a rebound?

In our base case, in which the virus remains under control in China and is brought under control in developed markets in 2Q, we expect markets to end the year sharply higher than today's levels. But a sustained rally will likely require:

1. evidence of successful virus containment in developed markets;
2. clarity on the net economic impact; and
3. a concerted global policy response.

In the absence of these factors, and amid high levels of volatility, it is clearly possible that markets could trade at lower levels from here in the coming days or weeks.

One way investors can think about where markets might trade in a downside scenario is comparing to history.

• Since 1945, the average drawdown in bear markets has been 34.5%. Applying this to today's markets would imply the S&P 500 index bottoming around 2,200.

Another approach is to consider valuation, and applying a trough multiple on depressed earnings.

• A 10% decline in profits would imply 2020 S&P 500 EPS of USD 149. A multiple of 16x—which we think is a reasonable assumption for a trough multiple given the very low level of rates and inflation—would imply an index level of 2,375.

That said, we would not advise waiting for such levels to be reached before deploying capital. Potential catalysts for a sharp near-term rebound could include: announcement of a US fiscal stimulus, a boost to monetary stimulus, results of clinical trials on treatments for the virus, or evidence that the virus's spread could be limited by seasonal factors.

Furthermore, even after the current crisis passes, an aging global population, developments in healthtech, and recent strides in genetic therapies all offer opportunities for investors seeking long-term portfolio growth. The crisis may also accelerate longer-term trends in connectivity and localization, benefiting companies exposed to the fourth industrial revolution and digital transformation.

One way of navigating an environment of long-term opportunity, yet high volatility and potentially binary near-term outcomes, is to combine an averaging-in strategy with put writing.

One way of navigating an environment of long-term opportunity, yet high volatility and potentially binary near-term outcomes, is to combine an averaging-in strategy with put writing. Averaging-in enables investors to deploy capital while smoothing near-term bumps. For investors who can implement options, put-writing strategies can provide a return if markets don't rally, and allow pre-commitment to investing during dip-buying opportunities. Read more here.

If I feel like my portfolio still has too much risk, how should I protect my portfolio?

The best advice for investors is still to stick to their asset allocation strategy with its periodic rebalancing. However, investors who feel they want a more conservative allocation can consider the following strategies:

1. Ensure you have adequate exposure to high-quality bonds, which have proven their worth as a portfolio hedge in recent weeks, and consider shifting capital to dynamic asset allocation strategies that can be defensively positioned in such markets, but also add equity exposure when conditions improve. Read more here.
2. Consider exposure to gold, which has also shown value as a hedge, only down 2.4% during the S&P 500's drawdown.
3. Ensure you have sufficient liquidity, including credit lines, to meet short-term cash-flow needs. This reduces the risk that investors are forced to sell assets into volatile and illiquid markets, should the crisis persist.
4. Geographic diversification is also a key part of mitigating potential risks. Varying government responses to the virus are likely to have varying levels of effectiveness, and induce varying levels of local economic and market pain. Although emerging market equities have already outperformed developed markets by 4.8% in the past 6 weeks, investors with very low allocations to emerging markets should use the sell-off as an opportunity to increase their exposure to the asset class. China's relative success in containing the virus is likely to mean a more rapid economic rebound there than in other regions.

For more information on the response from policy makers to COVID-19, watch our video with Paul Donovan, Chief Economist Global Wealth Management.

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