Viral Panic: What Is the Endgame?

Paul O’Connor, Head of the UK-based Multi-Asset Team, discusses the purge of risk appetite across the investment world as the coronavirus spreads and considers the range of potential government measures and the quiet progress being made on containment.

Key Takeaways

  • Major stock markets globally have experienced some of the biggest sell-offs on record while fixed income markets have offered little refuge during the most recent phase of the sell-off.
  • The rapid growth in infection rates across the U.S. and Europe has been troubling. However, the growth rate in daily new cases in China and South Korea (and even Italy) has slowed.
  • History tells us that market shakeouts often create attractive opportunities for investors with longer time horizons once confidence returns to financial markets.

What started as a coronavirus-led de-risking of equity portfolios has mutated into a broad-based, multi-asset liquidation. The past three weeks have seen one of the fastest and gloomiest reappraisals of equity fundamentals of all time. The collapse in global stock markets has been the quickest-ever plunge from a market peak into a bear market. On Monday, March 16, the Nasdaq Composite Index had its worst day ever and the S&P 500® recorded its biggest daily drop since the crash of 1987. Many measures of equity market volatility have surged above levels last seen during the Global Financial Crisis.

Fixed income markets have offered no refuge during the last phase of the sell-off. Most government bond markets delivered negative returns last week, failing to provide their usual risk-hedging characteristics. U.S. long bonds have just experienced their most volatile 10-day period ever. Things have been just as turbulent in other hitherto-defensive assets, with investment-grade corporate bonds experiencing their worst week in the 20-year life of the major indices and gold delivering its worst weekly performance since 1983.

Long Bonds Have Never Been So Volatile

Source: Bloomberg, 3/3/2005 to 3/13/2020. Showing standard realized 10-day volatility for 20-year U.S. government bonds.

 

Last week’s oil shock jolted the global market sell-off into a dangerous new phase. Before this, investors were largely focused on evaluating the impact of COVID-19 on global growth, with attention focused mostly on commodities and stocks. The plunge in oil prices added a new influx of volatility and uncertainty to already-fragile markets, initiating a more urgent and broader de-risking. The mood shifted to panic as investors found themselves rushing for the same exits at the same time, triggering a self-reinforcing spiral of surging volatility and frantic position liquidation in most major assets.

The Worst Week Ever for Investment-Grade Bonds

Source: Bloomberg, 2/19/1999 to 3/13/2020, corporate bonds with a rating of BBB or higher.

 

The market rout has purged optimism and leveraged risk-taking from most asset classes. Systematic investors such as trend-followers and risk-parity funds have unwound huge long positions in both equities and fixed income. Looking more broadly across all investor types, we see most measures of consensus positioning and sentiment now close to levels last seen in 2008-09, during the Global Financial Crisis. The majority of positioning and sentiment indicators are now at levels from which contrarian investing has typically been well rewarded.

Recession Now Priced In

The scale of the pullback in equities and spread-widening in corporate bonds are consistent with financial markets having now more or less priced in a typical recession. However, while this shift toward more cautious asset pricing is a necessary condition for a market bottom in risk assets, it is not a sufficient one. The missing fundamental ingredient for a sustainable recovery in risk appetite is some evidence that the growth of global COVID-19 infection rates is peaking. Cleary, we are not there yet.

The rapid growth in daily coronavirus infection rates in the U.S. and in many major European countries over the past couple of weeks has been troubling. However, behind the gloomy headlines we can find some signs of encouragement, such as the slowing growth rate in daily new cases in China and South Korea. Even in Italy, the country that has seen the greatest pressure on its health care system so far, the daily growth of new infections has been trending lower for a month. But the Italian daily growth rate is still in the mid-teens, which is uncomfortably high. With infection rates still accelerating in many major countries, broader evidence of containment will be needed to extinguish some of the more ominous, yet plausible, coronavirus scenarios.

In recent days, we have seen several attempts by global policymakers to ease the financial and economic tensions associated with COVID-19 disruptions, but efforts so far have had very little impact on market sentiment. The 12% drop in the S&P 500 the day after the U.S. Federal Reserve cut interest rates to zero says it all. Central banks are by no means out of ammunition, but they certainly do not have as much scope to revive market sentiment as they had during market sell-offs in the past.

No Game Changer

We agree with the consensus view that fiscal solutions are now needed. A range of targeted measures, such as credit guarantees, wage subsidies, tax holidays and direct payments to households, has been announced in many countries recently, but the overall fiscal impact has been fairly modest so far. While measures like these have a useful role to play in addressing specific tensions, a much bigger fiscal thrust will be required for policymakers to have a sizable impact on broader economic and market sentiment.

In the absence of any game-changing policy interventions, market sentiment looks set to remain hostage to perceptions of global trends in the coronavirus infection rate. Although many worrying potential outcomes still loom, it is worth noting that there is a wide range of views among the scientific community about the COVID-19 endgame. While the headlines will inevitably remain filled with the most dramatic coronavirus stories, it is important to keep sight of the quiet positive progress that is being made on containment in some countries. With so much pessimism now embedded in asset prices, we believe that gradually rebuilding market exposures into dips will be rewarded in all but the most adverse coronavirus outcomes. We approach these turbulent markets cautiously and probabilistically, but optimistically.

History tells us that shakeouts of leveraged positions in financial markets often create attractive opportunities for investors with longer time horizons. We would note that market moves this year so far would have shifted the weights of a representative 60%-40% equity-bond portfolio to something closer to a 52%-48% split. Investors will have some sizable rebalancing trades to do once confidence returns to financial markets.