Markets Hit an Air Pocket

Markets have hit an air pocket as investors grapple with uncertainty over the ongoing coronavirus outbreak, and we see more scope for near-term volatility in February as the US Democratic Primaries come into focus.

Global equities (MSCI All-Country World Index) rallied about 15% from October 2019 to January 2020. When markets move at this speed, an unexpected 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 beginning to show, such as falling levels of implied volatility and limited short interest across various risk asset classes.

The 2019 novel coronavirus outbreak was an unexpected speed bump for the markets. 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 see 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.

In our view, the coronavirus outbreak alone is unlikely to cause lasting damage to the global economy, and this correction is ultimately one to buy. But it is now too early 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, investors would do well to prepare to bottom fish selective stocks with firm long-term fundamentals as their 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 market 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.

The Democratic primary is a path-dependent process, which means that 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 important 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.

Notwithstanding the scope for market volatility ahead, the good news is that the fundamentals of this economic expansion remain broadly intact. This virus outbreak will temporarily impact growth sharply but is unlikely to cause long-term damage to the global economy, especially as policy makers stand ready to offset the hit through stimulus.

Incoming data continue to strengthen our view that 4Q19 was the low point of the latest global growth slowdown due to the trade war. Given the lack of capacity at this late stage of the cycle and some lingering drags, the subsequent economic recovery is likely to be a modest one.

History shows that the combination of accommodative monetary policy settings, abundant liquidity conditions, and economic reflation – all of which are in place today – tend to form sustainable headwinds for the markets.

Even though we have seen a correction over the last two weeks, the performance of global equities has so far been tracking in line with the average path of the last four historical episodes when global growth hit bottom and rebounded, which points to a broadly constructive backdrop for markets despite some air pockets ahead.