Article written by Morgans

as at 17 March 2020


Equity Strategy : Peak uncertainty will subside

We offer context and a re-iteration of our Strategy for equity investors during unprecedented volatility.

The COVID-19 outlook

The trajectory toward a return to normality in people’s daily lives, the economy and in markets will depend on the timing of the management of the virus. At this stage management is about containing the spread. This is A major unknown, with well publicised implications. What we do know is that management of the virus will occur, and we can take encouragement from recent trends in both South Korea and China (with a grain of salt) where there is clear improvement in infection data.

What’s next – A tough 2-3 week view

The immediate challenge is that the US and to a lesser extent Europe are only at the start of their infection cycles. The health data (and headlines) here may get worse before they get better. It’s also likely we’ll see social containment measures escalate globally, with clear implications for business, earnings and markets.

What’s next – A sensible 2-3 month view

Key governments forecast (either overtly or by implication) a peak in their infection rates ranging from April (Aus), to July (the US) or longer (Germany). Any estimates made now are almost certainly going to be wrong. But given the progress of South Korea, and the escalation of controls, we do think its realistic that a slowing in the infection rate, leading to more accurate estimates of a peak, will become a focal point of public discussion within a few months. While the crisis would be far from over, this would be a critical milestone for markets.

The Global Economic view

The risk of a global recession developing over the coming months is now looking a more likely scenario. However policymakers still have the tools to prevent a recession from turning into a financial crisis and economic depression, and there is plenty that they can do to aid the recovery once the effects of the virus fade. We continue to believe that the massive liquidity injections now being made will overwhelm volatility in the financial system, and a plausible base case is a relatively brief contraction. This is contingent on controlling the spread of the virus in the near term.

What is equity market behaviour telling us?

When perceived safe havens like bonds and gold sell-off in unison with equities – as they have this week – it’s clear that asset markets are malfunctioning. It appears that investors have traded fear over fundamentals, liquidating any assets in favour of cash. Think about what else we know to support this. 1) markets they have a great capacity to over-react to both fear and euphoria; 2) the rise of machine trading is likely compounding volatility; 3) as may unwinding of passive ETF momentum; and 4) as may forced fund redemptions.

What are equity market valuations telling us?

Economist Michael Knox’s modelling of the S&P500 suggests that US earnings need to fall by more than 25%, and to stay there for an extended period, in order to justify the current low valuation of the US market. This is an earnings scenario comparable to the 2008-09. In other words, financial markets have moved quickly to assume we face a global depression akin to another GFC. At this stage Michael thinks this implication looks too far overdone.

Views, Equity Strategy & Tactics : Facts will help the fear to subside

Markets hate uncertainty. They are clearly discounting it now, trading on fear over fundamentals. This will revert as more clarity emerges on the health emergency.
The sheer scale of co-ordinated global fiscal stimulus will absorb market volatility, we think within a few months. Never underestimate the ingenuity of human beings to overcome adversity.
Equity markets are likely to bottom out when it becomes clear that the flow of new cases of the virus has peaked. This data will improve before the economic data will.
Eventually the release of pent up economic activity/demand, against a backdrop of zero interest rates, has potential to drive a recovery in risk assets like equities. The upswing could be very rapid.
Dip your toes in. Deploy spare capital in stages to capitalize on equity opportunities at compelling value (e.g. APA, SYD etc).
No panic lasted forever, nor will this one. Heed the advice of Buffet & Marks: Investors never get a rosy outlook and an amazing outlook at the same time….. Equity prices start rising while events are still at their darkest.

Unmatched volatility – The pace of the S&P500 pullback is unmatched in our generation. Markets have been quick to assume the worst, potentially compounded by artificial forces (ETFs, etc).

Unmatched volatility – Volatility has only been higher during the depths of the GFC. The VIX touched 75 this week.