16 March 2020
The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole.
The material weakness of oil prices, resulting from the recent inability of Saudi Arabia and Russia to agree the quantum and the share of production cuts in response to the sharp weakening of demand, has amounted to a second shock to markets following the spread of the coronavirus (COVID-19). This has compounded the sense of uncertainty, which in turn has resulted in disorderly price action across asset classes.
Market weakness itself has the potential to become a third shock, through the mechanism of tighter liquidity conditions and a negative impact on wealth. At this point, markets are heavily oversold in the case of ‘growth’ assets such as equities and credit and overbought in the case of ‘defensive’ assets, such as government bonds. Poor market liquidity, more positive investor positioning coming into the new year and financial leverage have combined to produce the extreme price action that has been witnessed recently. Now we are anticipating a further period of uncertainty and volatility as market participants seek to get a clearer understanding of the scope of the impact of the coronavirus outside China, especially in the US, and what measures governments and central banks may take to underpin growth and offset the shock to liquidity. Although the two other ‘shocks’ have emerged, the impact of the coronavirus is likely to remain the pre-eminent source of market uncertainty.
So far, productive efforts by China to contain the virus, including in the Wuhan district where it first appeared, have been overshadowed by the acceleration in the number of cases recorded elsewhere in the world. For the moment, the impact of fear may be disproportionate to the actual risk represented by the virus itself. At the time of writing, over 100,000 cases have been reported globally. Even if many cases have gone unreported and the true figure is closer to 200,000, this is still a relatively modest number. Furthermore, 80% of reported cases have not required hospitalisation; 17% have required hospitalisation but haven’t resulted in fatalities; and 3% of cases have resulted in death. These statistics compare favourably with both the SARS (2003-4) and MERS (2012) viral outbreaks. For uncertainty to subside, investors need to see the trajectory of the spread of the disease to be firmly on a downward path in Europe and the United States. The longer that takes, the greater the economic disruption and the higher the risks are for a more negative outcome.
The key judgement to be made by investors is whether this combination of shocks is sufficient to cause the world economy to slip into a sustained recession or whether global economic momentum (before the outbreak) combined with further policy responses globally will prove sufficient to allow it to withstand the shorter-term impact of the prevailing uncertainty on economic activity. Notwithstanding the continued negative price action in markets, the response by policy makers is now ramping up. This is particularly true of the United States where official rates were slashed a further 100 basis points over the weekend to close to zero after an initial 50 bps cut, together with other steps to bolster Dollar liquidity. Should this be the case then there is a good chance that the current market ‘crash’ will prove to be similar to those of 1987, 1998, 2008 and 2011 – telescoped bear markets triggered by events and prompting relatively rapid supportive policy actions and without lasting economic contractions.
We believe that the balance of probabilities strongly suggests that the impact will be more modest than is currently feared. The US economy has continued to display robust growth, led by solid consumer demand and construction. Elsewhere, the downturn in manufacturing, which had characterised 2018 -9, had been showing signs of ebbing from the last quarter of 2019 as companies started to rebuild inventories. Developments in China appear to be constructive. The spread of the virus has been contained by the draconian response by the authorities, and the probability is that the interruption to global supply chains – to which China remains critical – will be limited to the first half of the year. President Xi has announced his intention to visit Wuhan, the epicentre of the coronavirus outbreak. If the pattern is similar in the West, the actual disruption could prove to be much more limited than markets currently fear. While lower oil prices – if sustained – can be disruptive in the short term, they are the equivalent of a tax cut for consumers worldwide. Notwithstanding, the shock to investor confidence will have to be worked out in the form of a period of volatile consolidation.
For a more negative outcome to play out, the interaction of the ‘three shocks’ on economic activity would have to be more material and lasting, resulting in a deeper and, in all probability, more drawn out bear market in growth assets. The longer the disruption the more risk there is of such an outcome.
Market prices have already moved materially to reflect such an outcome as investors have de-risked. Significant relief rallies are likely to occur even under this scenario, potentially offering opportunities to rebalance if the environment shows signs of longer-term damage to final demand. However, under this scenario an eventual market low point could be some way off.
Investors are currently placing a very low probability on a strong rebound in activity in the second half of the year, but such an outcome should not be dismissed. Briefer-than-anticipated disruptions to economic activity combined with solid underlying US and Chinese economic momentum, weaker oil prices and even looser monetary conditions could eventually combine to produce a positive shock.