Markets have hit an air pocket as investors grapple with uncertainty over the new coronavirus outbreak, and we see scope for more near-term volatility in February.
Global equities (MSCI All-Country World Index) rallied about 15% from October 2019 to January 2020. When markets move at this speed, any speed bump can result in a disruptive consolidation as investors experience a reality check and take opportunities to lock in profits.
Moreover, we entered 2020 with risk assets valuations broadly above average levels, and as can be expected after a sharp rally, some signs of complacency were setting in, such as falling levels of implied volatility and limited short interest across various risk asset classes.
Exhibit 1: Equity implied volatility declined significantly over Oct 2019 to early Jan 2020
Source: Bloomberg, Bank of Singapore
The 2019 novel coronavirus outbreak was an unexpected speed bump for investors. There is still much uncertainty as the situation continues to evolve, and our base case at this point is that the virus outbreak would likely impact China’s annual GDP growth in 2020 by 0.5% to 1.0%, with the risk of a more severe impact if this epidemic is an extended one.
Taking a leaf from the SARS playbook, we foresee more near-term pain before relief for investors. During the SARS episode, the markets corrected as the outbreak escalated and only hit bottom when the rate of infection peaked, before staging a sharp recovery as the number of new cases began to stabilize.
The coronavirus outbreak alone is unlikely to cause lasting damage to the global economy, in our view, and this correction is ultimately one to buy. It is likely too early, however, to buy broadly on dips when the outbreak is still in its escalation phase.
Not surprisingly, the major sectors that have corrected significantly due to virus fears are those hit by reduced consumer demand, such as airlines, travel agencies, restaurants, brick-and-mortar retailers, and Macau gaming. While we expect more downward pressure on these sectors as the epidemic escalates, we recommend that investors position themselves to bottom-fish at selective stocks with firm long-term fundamentals as prices fall into bargain territory.
Looking ahead, we believe the US Democratic primary - a key milestone in the 2020 US Presidential Elections - is another potential catalyst for near-term volatility that investors need to watch. Although Joe Biden, a moderate, is leading in the national polls, progressive candidates Sanders and Warren, who are campaigning on less market friendly agendas, are not far behind.
It is important to note that the Democratic primary is a path-dependent process, and the results in Iowa would boost the winner’s national prominence and create positive momentum for New Hampshire and possibly the Democratic nomination. If Sanders or Warren did garner early wins and some momentum, it is easy to see why investors would be concerned, especially as Trump’s approval ratings remain stubbornly low and his odds of re-election persistently in question.
Despite market volatility, the good news is that the broad fundamentals of this economic expansion appear to be mostly intact.
The virus outbreak will temporarily impact economic growth but is unlikely to cause lasting damage, especially as policy makers stand ready to offset the hit through stimulus. Incoming economic data continue to strengthen our conviction that 4Q19 was the low point of the latest growth slowdown. Given the lack of capacity at this late stage of the cycle and some lingering drags, we expect the economic recovery to be a modest one.
History shows that the combination of economic reflation, accommodative monetary policy settings and abundant liquidity conditions – all of which are in place today – tend to form sustainable headwinds for the markets.
Despite a correction in risk assets over the last two weeks, the performance of global equities has so far been tracking the average path of the last four episodes when global growth hit bottom and rebounded (1995, 1998, 2012 and 2016), and this suggests a constructive backdrop for markets ahead.
Exhibit 2: Market is so far tracking typical path when global growth bottoms
Source: Bloomberg, Bank of SingaporeDisclaimer applicable to recommendation
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Version: December 2019