Making sense of market sell-off amid virus concerns

Financial markets have been roiled this week as the coronavirus outbreak took on a global scale. Major markets such as the S&P 500 are down by roughly 8% as of market close on 26 February. Implied market volatilities as a measure for risk aversion jumped to levels not seen for quite some time, with the VIX volatility index spiking to 30 on 25 February, the highest level since 2018. In fixed income, government bond yields reached new lows as investors sought protection. 

Lower growth expected

The fact that the virus has been spreading internationally has also increased the risk of further damage to global growth, with a high uncertainty over the ability to contain the outbreak, at least in the short term. In response, we have further reduced our gross domestic product forecasts for the first quarter. However, revisions to our annual forecast for 2020 are less dramatic as we expect a pick-up in growth in subsequent quarters to offset large parts of the initial shortfall. We now expect the global economy to grow by 2.2% this year, down from 2.4%, with the US economy growing at 1.7%, down from 1.8%, and the Eurozone economy growing at 0.5%, down from 0.9%. 

Nervousness set to remain high

For financial markets, this implies that we will go through a period of heightened nervousness that could continue for several weeks or even months. During that period, we expect further drawdowns, but also rebounds, for instance should monetary or fiscal policy measures be announced to offset the economic impact. What is important for the longer-term orientation of portfolios is that we think that the global economy will face a slowdown but will be able to weather this blow. 

No time to panic

Tactically we therefore maintain our neutral stance on equities. We keep a moderate overweight allocation to commodities, as we think that recent price action in oil markets and base materials already discounts too pessimistic a growth scenario. With China ramping up production again, the demand shortfall should be contained.

The most important thing is not to panic. While volatility is increasing and cyclical markets such as equities and commodities have suffered significant setbacks, we would argue that the fundamental situation of most asset classes has not changed all that much. Indeed, we could see a relief rally in cyclical markets as the peak of the outbreak passes. The problem is that this is very difficult to time. 

Diversification is the best hedge

As markets have started to correct and volatility has spiked, implementing an outright hedge is now very expensive. Yet a well-diversified portfolio provides the best hedge. If markets correct more meaningfully, we would see this as a chance to begin buying equities. For now, it is prudent to stay on the sidelines.