For financial professionals only
Sentiment and growth wobble, valuations improve
Markets last week finally woke up to the negative implications of the growing global spread of coronavirus.
Initial views that it was largely a Chinese problem, with isolated cases elsewhere in Asia and the Middle East, left investors indifferent and markets held relatively firm, despite the daily rise in number of reported infections and deaths.
This all changed as news of quarantines in 12 Italian towns, quasi lockdown in Daegu city in Korea, a profit warning from Apple and the cancellation of tech conferences in San Francisco led to a reassessment by investors. Now the virus was a global issue, the expected peak of new cases became harder to predict. This saw accelerated downgrades to growth and corporate earnings, and an immediate shift in sentiment as relative calm gave way to a spike in risk aversion. You can see this in the CBOE SPX Volatility VIX chart, often referred to as the Fear Gauge, below.
CBOE SPX Volatility VIX – the Fear Gauge
Source: FE Analytics
Markets don’t like uncertainty, so this change in sentiment should not come as a surprise. However, the speed and magnitude of the change was exacerbated by the overwhelming expectation that growth in 2020 would pick up from the lows seen at the end of last year. Signs of improvement were already in evidence, as you can see by the tick up in regional growth in the chart below.
BlackRock Growth GPS for Developed Market Economies, 2016-2020
Source: Blackrock and Consensus Economics
Expect growth to be delayed, not derailed
These growth assumptions are now being pulled back, quite materially in certain countries such as China. Yet most economists assume the disruption will delay rather than derail economic growth. The virus is expected to peak sometime in the second quarter, indicating only a temporary slowdown.
In the short term though, high frequency data is expected to deteriorate. Leading indicators such as the February IHS Markit Flash US Composite PMI (a reasonable guide of future economic activity) show a marked downturn for the world’s largest economy.
IHS Markit Composite PMI and US GDP
Source: IHS Markit, US Bureau of Economic Analysis
Take a balanced view
The critical element for investors is trying to ascertain the severity and duration of the slowdown. This is notoriously difficult. Many look to history as a guide, noting the V shaped recovery following the SARS crisis in 2003, or the Zika outbreak in 2016.
The problem with that is, firstly, no two viruses are the same. Secondly, China’s impact on the global economy is far greater today than it was in 2003. China now makes up around a third of global growth, and global manufacturing supply chains are much more integrated. If China catches a cold, so may the rest of the world.
Most importantly, services now make up over 60% of most western economies. If the knock-on impact is that staff (and therefore consumers) are consuming less, or worse, confined to their homes, then the drop in service sector supply and demand is likely to be notable.
There is a flip side to this. Medical science has advanced materially over the years and coordinated policy responses dramatically improved. For example, there is already a vaccine proven to combat COVID-19 and clinical trials are underway. By contrast, in 2003 it took scientists five months to even identify the SARS virus, never mind develop a vaccine.
Furthermore, greater flexibility in working environments and use of technology that many employees enjoy around the world should allow better control and therefore mitigation of the spread of the virus.
Look to the long term
To offset the weakness in consumer activity, governments are expected to initiate supportive fiscal policies. This should help prop up growth and, combined with accommodative central bank monetary policies, ensure that any slowdown is only temporary. As such, it is expected that full year global growth for 2020 will be positive, though as ever there will be regional variations.
Where markets do seem to have got a little ahead of themselves is in government bonds. With the compression in government bond yields as investors have sought safety, expectations have grown that central banks will cut rates materially, and soon. This looks somewhat optimistic, given there is finite room for further easing and the banks are likely to assume the impact of the virus is temporary. They may well want to retain some firepower and optionality for when the economic impact becomes clearer.
Professional investment management at work
The focus for Parmenion’s investment team remains on delivering attractive risk adjusted returns in line with clients’ expectations for each Risk Grade within all our solutions, over the medium to long term.
The robust and proven risk framework underpinning our strategic asset allocation (SAA) is built to support long term investing, able to withstand unpredictable shocks such as the coronavirus, as well as more conventional market, economic and political cycles. As such, our SAA is unaffected by this short term challenge.
For our Tactical solutions where we can adjust asset class weightings, analysis is on-going. Despite alarmist headlines, it is important to remain calm, measured and disciplined. With lots of unknowns, we will remain focussed on scrutinising developments and relative market dynamics, but as communicated in our recent Tactical solution update for advisers, we are cautiously optimistic.
Our update highlighted that we have adjusted weightings towards those asset classes offering either compelling value, for example UK equities, or risk mitigation characteristics such as Index Linked Gilts. Meanwhile, we reduced exposure to asset classes where projected returns are not in line with the risk being asked of investors, for example in Corporate Bonds.
Regardless of the asset allocation methodology, the scrutiny and detailed analysis of our fund selection remains paramount. Our process seeking to identify managers that have a clearly defined investment philosophy, process and risk discipline to deliver compelling risk adjusted returns to support the sequential alignment of our Risk Grades is robust, repeatable and proven.
That said, we are always looking to improve where we can. Over the last year, as markets have climbed progressively higher, focus on risk controls by our selected managers has intensified. We have also increased our challenge on their valuation methodologies and underlying liquidity. As the economic cycle lengthens, we believe it is critical to make sure that margins for error and analysis of potential downside are fully considered. Valuation is a key element to that.
Recovery and opportunity
As long-term investors, we consider the prevailing volatility in markets as predominantly a sentiment-driven shift to a temporary slower growth outlook, on the back of short economic disruption.
Earnings expectations have been pulled back, and while we are likely to see further downward adjustments, we expect them to remain positive for the year as a whole.
Technical recessions cannot be ruled out, such as in Japan and parts of Europe given their soft GDP growth in Q4 2019, but they are expected to be short term.
Assuming that we reach the global peak of new cases of the coronavirus in H1 2020, it is expected that full year global growth will benefit from the subsequent recovery as normality resumes.
This will support a recovery in corporate earnings, helping to underpin market valuations. Given the theory that the return on your investment is primarily a function of the value you pay, the lower valuations presented following the recent market weakness should actually be welcomed as a potential opportunity, not feared.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.