The correction may not be finished yet.
Gérante de portefeuille
[Invest. Pro.] Intended for Professional Clients in accordance with MIFID.
Following the spread of the Covid-19 virus outside of China and the economic paralysis of almost all developed and emerging economies, recessionary risk has increased dramatically in the past two weeks, causing a massive correction on global stock markets by 20% on average, compared to the highest points of February 2020. Is the corrective movement coming to an end? We do not think so. Analysis of the risk environment shows that equities remain overvalued. Even if a technical rebound is very likely in the short term, the correction could extend beyond.
Equities remain overvalued
In the past two weeks, equities have only erased the exacerbated over optimism they had accumulated in January and February. Analysis of risk environment (chart 1) tends to show that the correction may not be complete. Worse, it might have only gone half the way.
Chart 1: US Equities Performance over the next 12 months & Expected Volatility Regime (proprietary models) – sources: Seeyond, Bloomberg, data as of end of December 2019 regarding Volatility Regime and as of 9th March 2020 for US equities
The capitulation day the markets experienced on Monday, 9th March 2020 is conducive to a technical rebound on the very short run. This “black” Monday could thus punctuate the first corrective episode on risky assets. However, in the wake of downward revisions on both global growth and profit expectations, a second wave of market drop is not excluded, and the amplitude could be close to that experienced by the markets since the end of February.
Short term financial risks
In the short run, the containment measures taken by China but also by an increasing number of economies affected by the Coronavirus epidemic lead to a double macroeconomic shock: on the one hand, a supply shock via the serial breaks in global supply chains, on the other hand, a demand shock via the decline in household economic activity.
Recessionary effects are amplified in the short term by:
- the structural rise in world customs tariffs (customs tariffs between the United States and China have increased sharply, from 3% in 2017 to 19% in 2020). These ones will penalize world trade for a long time (chart 2)
- the fall in the price of oil and industrial raw materials against the background of a growing geopolitical crisis. It will mainly hit the net oil-exporting countries, countries of which the United States is now a part.
- the currencies shocks suffered by the most fragile economies, following the disorderly and uncoordinated interventions of the world's largest central banks.
Contrary to what political and financial authorities could have dreamed of a month and a half ago, domestic demand will not be able to take over from external demand in the main developed and emerging countries. At the end of November 2019, world trade was already at levels that, historically, led to a recession (chart 2) and the global leading indicators pointed to a further slowdown. The Covid-19 crisis, which will affect the global IFO indicator in April, will undoubtedly mark an even stronger inflection.
Chart 2 : World Trade & Global Manufacturing Confidence – sources: Seeyond, CPB Trade Monitor, data as of end of December 2019 for Manufacturing Confidence & as of end of November 2019 for World Trade
Medium term financial risks
In addition to the risks of global recession caused by the a priori temporary health crisis linked to the Coronavirus, we perceive increasing risks of collateral damage that could, this time, strike more deeply and more durably world growth, through the financial channels, limiting the probability of a “V” shape recovery in the coming months.
- Increasing risk on the HY
Following the breakdown of negotiations between Russia and Saudi Arabia, this Friday, 6th March 2020, during the OPEC crisis meeting, oil price collapsed. It lost nearly 25%, hurting the whole oil & gas sector. The US HY segment is under pressure via the Schyste petroleum sector. The risk premium on US HY debt is now above the levels of end of December 2018, and is approaching the levels hit during the crises of 2011 and 2016 (chart 3).
Chart 3 : US HY Spread – sources: Seeyond, Bloomberg, data as of 9th March 2020
- Increasing risk on the EM debt
The fall in the prices of oil and industrial raw materials will penalize net exporting countries of raw materials. If Latin American countries are the most directly exposed to this oil counter shock, China could also suffer the negative collateral consequences via loans backed by natural resources that it has granted to South American and African companies to facilitate Chinese companies access to raw materials.
Seeyond's multi asset management team has a conservative scenario for risky assets since the end of December 2019 (see "So Far, So Good", Outlook Seeyond 2020), based on an overvaluation of equities regarding the expected volatility regime for 2020.
In the short term, we believe that uncertainties are still too high to become constructive again on risky assets. In particular, we note that: 1- the management of the Coronavirus crisis in China takes more time than initially anticipated, despite the drastic measures taken by the Chinese authorities to contain the epidemic. These measures could be difficult to apply in Western democracies. 2- the spread of the Covid-19 outside of China is only at its early stage and we are expecting an exponential increase in cases outside of China - in Europe and the United States in particular - in the coming weeks.
Just as the stabilization of industry confidence indicators put an end to the market downturn in March 2009, we believe that stabilization of new Covid-19 cases worldwide will put an end to the corrective movement on the financial markets.
In the longer run, we see two alternative issues:
- either the health shock remains contained in its duration (peak in new cases of Covid-19 outside of China in April) and a rapid economic recovery is possible, accompanied by a sustainable equity markets recovery,
- or the health shock is longer than expected (peak beyond June) and collateral financial damage comes to further penalize global growth - already out of breath in certain regions - via the credit channel.
In both cases, it seems that global coordination of monetary and fiscal measures is necessary.
Written by Stéphanie Bigou, Global Macro Portfolio Manager at Seeyond, 10th March 2020
This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.