Coronavirus Fears Lead to Sharp Market Sell-Off
Escalating fears of the coronavirus turning into a global pandemic led to a sharp sell-off in the S&P 500® in late February. The index fell about 13% from its February 19 high, its quickest peak-to-trough correction in history. The selling was indiscriminate, with stock correlations moving sharply higher as investors quickly moved to reduce US equity exposure.
Overall, 96% of the stocks and all 11 sectors in the S&P 500 closed the month in correction territory (down 10% or more). For the month, the broader S&P 1500® closed down 8.3%; the S&P 500 (large-cap stocks), down 8.2%; the S&P 400® (mid-cap stocks), down 9.5%; and the S&P 600® (small-cap stocks), down 9.6%.
Leading into the late month sell-off, it was our view that US equity markets had been somewhat complacent to the downside risks of the virus. This was evidenced by the aggressively bullish technical backdrop following a record run for US stocks in 2019. Ultimately, the rise in new reported cases outside of China and concerns about further global contagion served as catalysts for the market pullback.
While the speed of the sell-off and the headlines have been alarming, we continue to believe the ultimate economic and investment impact of the coronavirus epidemic for the United States will be transitory. This is not meant to downplay the seriousness of the virus spreading, or that the continued uncertainty from a rise in cases in the United States could present further downside risks in the near term. However, we believe the underlying fundamentals of the US economy remain solid, as evidenced by historically low unemployment, an improving US housing market, and solid consumer balance sheets. In addition, the positive benefits of falling US interest rates over the second half of 2019 and a roll-off of the US/China trade tensions should help provide additional support for economic growth. As such, we do not see the coronavirus driving the US economy into recession.
The fundamentals of the US equity market remain attractive as well, in our view. Fourth-quarter earnings delivered a blended growth rate of 0.9% (actual growth combined with consensus estimates), above the consensus estimate of -1.7% at the beginning of the quarter. While revisions for first-quarter 2020 are falling and likely to remain under pressure until the uncertainties of the virus impact come into greater focus, current 2020 earnings-per-share estimates are for still-solid growth of 7.6%, although this is down from the 9.6% growth estimate leading into the year.
Following the market sell-off, the forward price-to-earnings ratio of the S&P 500 ended the month at 16.6 times (x), back to levels seen in October 2019, after notching a new business cycle high of 19.0x earlier in the month. Prior to the multiple contraction, we were not overly concerned with US valuations making new cycle highs amid the solid earnings backdrop and accommodative monetary policy. Overall, despite the near-term uncertainty from the virus impact, we see the solid growth outlook and the market’s reasonable valuation as offering a path higher for equities in 2020.
Pullbacks following periods of strong performance are normal for a well-functioning market. Furthermore, market drawdowns that coincide with a strong fundamental backdrop typically represent good buying opportunities over the long term rather than a time to panic.
For historical context, the average S&P 500 intrayear peak-to-trough decline since 1980 is almost 14%, while the average calendar year return has been 10%, with the market closing in positive territory 30 of those 40 years.
We believe the political calendar may have played some part in the sell-off as well. After winning two of the first three state primaries in New Hampshire and Nevada and coming in a close second in Iowa, Senator Bernie Sanders was increasingly seen as the likely nominee for the Democratic party in this fall’s election. No candidate, from either party, has gone on to win two out of the first three state primaries and failed to win their party’s nomination. However, former Vice President Joe Biden’s commanding win in the South Carolina primary appears to have interrupted the Sanders momentum. As we detailed in our 2020 market outlook (see our First-Quarter 2020 Strategy Insights, 20/20 Vision), the election has the potential to be highly polarizing given the stark differences on the big policy issues of the Democratic candidates versus the policy positions held by President Donald Trump.
Falling interest rates were the primary driver of core fixed income returns in February, helping the Bloomberg Barclays US Aggregate Index to a 3.76% return year to date, the index’s strongest start to a year since 1995.
The rally in government bonds pushed 10- and 30-year Treasury yields to new all-time lows of 1.15% and 1.68%, respectively, as investors assessed the impact of the coronavirus on global economic growth as well as the Federal Reserve’s (Fed’s) path for policy rates in 2020. Federal fund futures are now pricing in three rate cuts in 2020, a stark shift from just one expected cut at the beginning of January. With financial conditions at their tightest level in five months, an inverted 3-month to 10-year portion of the yield curve, and falling inflation expectations, the pressure on the Fed to cut interest rates has certainly increased but will ultimately depend on the severity of coronavirus contagion over the coming weeks, in our view. As of this writing, the Fed has made an emergency cut to the federal funds rate of 50 basis points (bps).
In corporate bonds, contagion fears hampered primary market activity toward the end of the month, with spreads widening in both high-yield (HY) and investment-grade (IG) rated debt. Year to date, the 164 bps of HY spread widening has resulted in underperformance (-1.38%) versus the 3.7% return in IG corporate debt. We continue to view the riskoff move in credit spreads as largely fear driven and not necessarily reflecting a prolonged downturn in economic growth that would be cause for a wave of downgrades for lower-tier IG debt.
International Developed Markets
Despite Hopeful Signs of Macro Recovery, Developed Markets Cannot Catch a Break
Developed international economies, in particular Europe, cannot seem to catch a break. Headlines about coronavirus concerns (especially in Italy), risks of a disorderly Brexit, and potential trade tensions present hard-to-gauge risks and have distracted from a number of upbeat trends in the underlying fundamentals across key countries in Europe. For example, some manufacturing and sentiment survey data have actually improved over the past month, the services sector has been resilient, accommodative monetary policy remains a key support, and consumers generally remain healthy.
While economic growth continues to be stagnant in Japan, we still do not believe developed markets as a whole are facing imminent recession, but a reprieve from a variety of macro overhangs is key for improving the global growth outlook.
Toward the end of February, renewed fears surrounding the coronavirus sent global equities sharply lower, with the MSCI World ex USA Index declining nearly 9% on the month. As an example of some of the indiscriminate selling in Europe, during the last week of the month stocks in the United Kingdom posted their worst day in nearly five years, and Italian shares fell nearly 6% in a single day. Japanese stocks were down nearly 9% for the month, their worst decline since December 2018. While these fears sparked plenty of headlines and ushered in volatility, it is important to remember most major indexes had just reached all-time highs and that the longer-term tailwinds, such as improving earnings and accommodative monetary policy, remain intact.
Fourth-quarter earnings reports from companies in the MSCI World ex USA Index show that with just over 85% of companies reporting results, roughly 47% are beating expectations. Although the blended growth rate for the quarter has been disappointing, the outlook for earnings growth in 2020 continues to remain solid at 6%.
Despite a variety of near-term uncertainties, February European manufacturing survey data actually showed tentative signs of improvement in the region. The IHS Markit Eurozone Manufacturing PMI® increased from 47.9 to 49.2, exceeding market expectations and notching its highest level since February 2019. Although Greece, Ireland, and the United Kingdom are the only nations where manufacturing is technically expanding, the broader Eurozone index reflects resilience to macro headwinds and a potential shift higher after a generally downbeat 2019. Furthermore, Eurozone consumer confidence and the German Ifo index moved higher over the month, suggesting to us that consumers are well-positioned to continue supporting economic growth.
Similar to the United States, international developed government bond yields broadly declined in both Europe and Asia. Negative interest rates continue to act as a gravitational pull on global interest rates, in our view, with the market value of negative-yielding debt rising above $14 trillion for the first time since October.
However, investors have begun to be more concerned about higher-risk sovereign debt. Sovereign debt yields in Portugal, Italy, Greece, and Spain, affectionately known as PIGS, each moved higher at the end of February, finishing higher than their respective one-month averages. Central banks are likely to address the potential impact of coronavirus at upcoming meetings, which may entail a call for fiscal stimulus given limited capacity for additional monetary policy action.
Emerging Markets Outperform on a Relative Basis
Despite falling more than 5%, the MSCI Emerging Markets (EM) Index had stronger relative performance against the S&P 500 for the second month in the past three. Every single country within the index had negative returns, with the exception of China, which was up nearly 1%. Despite expectations for lower economic growth in the first quarter in China, the combination of significant fiscal and monetary stimulus measures acted as a counterbalance and helped deliver a positive move in the market. With more stimulus measures likely to be implemented by additional countries as concerns about the coronavirus spread, we remain positive on EM as an asset class.
As Chinese businesses slowly reopened after the Lunar New Year and the various quarantines of workers began to be removed, only limited economic data were released in February. However, data that were delivered were fairly positive, in our view. The month started with a better-than-expected Caixin China General Manufacturing PMI™ reading, although the survey likely did not include the full impact of the coronavirus as the month progressed.
Additionally, the Chinese Producer Price Index grew 0.1% on a year-over-year basis. While small, the number returned to positive territory for the first time since May 2019, indicating to us that accommodative monetary policy may be starting to show up in the economy.
Another metric indicating monetary and fiscal stimulus in China is trickling through the economy was new loan growth for the month, reaching an all-time high of 3.34 billion yuan. That number usually spikes in the month of the Lunar New Year, so it is important to look at that number on a seasonally adjusted basis. While the growth rate is slower than the previous two Lunar New Year periods, it is the third consecutive month of accelerating loan growth. Part of the reason we remain confident in EMs despite near-term volatility is the commitment from Chinese leadership to provide significant stimulus to promote economic growth.
Significantly underperforming the EM Index for the month were equities in commodity-heavy countries like Brazil and Russia, where significant declines in the Energy sector led to double-digit losses for the month. Virtually every subindustry for the Energy sector in the EM Index has missed consensus fourth-quarter estimates. Although these results are disappointing, the overall outlook for EM earnings in 2020 continues to be strong, with consensus expecting nearly 17% growth for the year. This growth further supports our positive outlook on EM equities.
Despite coronavirus fears largely emanating from EM countries in the Asia-Pacific region, dollar denominated EM debt garnered a positive return in February, bringing the year-to-date total return to 1.34%.
Duration (interest rate sensitivity) and currency hedging were the primary drivers of return for the month, with credit spreads widening and EM currencies weakening against the dollar. We continue to view EM debt as an attractive opportunity, given higher yields and economic growth, compared to developed market peers.
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