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Market Ills – or a Healthy Pullback?

As the COVID-19 strain of coronavirus spreads, so does the temptation to blame it for all of the recent changes in market conditions.

But this bears closer examination. It’s important to distinguish, as best as we can, the probable from the possible, and to position portfolios accordingly. Risks are certainly rising but we remain confident investors, striving to build robust client portfolios able to withstand even severe market fluctuations.
 
U.S. equity market valuations had become rich. At over 19x forward earnings, up from 14x in the near bear-market of December 2018 and in the context of relatively modest investor expectations for 2020 corporate revenue and earnings growth, the U.S. stock market had little margin for error as of the recent highs on February 19, 2020. As we stressed in our most recent quarterly update, opportunistic rebalancing is important.
 
U.S. bond market yields hover at levels generally unseen since the Great Depression. The yield on the 10-year Treasury closed on February 25 at 1.34%, a near-record low, on concerns of slowing economic growth and persistently low inflation: the curve is now pricing in two full Fed rate cuts in 2020. The yield curve (measured by the difference between the three-month T-Bill and the ten-year Treasury) is again inverted, a leading indicator of recession. It is important to note that other U.S. economic data remains positive. Unemployment remains near historic lows, productivity growth is rising, and inflation remains low.
 
China’s economy continues to slow. Deteriorating conditions in the world’s second largest economy and the – by far – largest driver of global growth have been clear for years. Economic growth, while still robust by global standards, continues to decline. The coronavirus will not help: some current estimates are that China’s GDP growth could stall or even be negative for a quarter or two, although of course no one really yet knows. But the China slowdown itself has been weighing on global investors for some time.
 
Feeling the Bern. Vermont Senator Bernie Sanders’ convincing weekend victory in Nevada (the most diverse state to hold a caucus or primary so far) has made the self-described democratic socialist the odds-on frontrunner for the Democratic nomination. The market had previously underpriced the likelihood of a Sanders nomination and even further discounted a victory in the general election, but his successes are forcing a rethink. The policy differences between President Trump and Senator Sanders is stark and will create significant policy uncertainty.
 
Risk is rising. No one knows yet how this virus will develop. The possible impact on China and elsewhere is potentially extremely serious, with worst-case scenarios including social and political upheaval and worsening damage to supply chains and consumer demand that could lead to a full-blown recession in China and other markets, including the United States. And of course, no one really knows what will happen in the U.S. election.
 
It is our view that a pullback of 10%+ in the S&P 500 from the all-time high it reached on February 19 will prove positive for the long-term health of the market, allowing stock valuations to reconnect with their underlying fundamentals and encouraging investment. As of today’s close the market is down 7.6% from the high, and we believe the above outcome is much more likely than the 20% plus decline that would represent a bear market and suggest recession.
 
We will be monitoring these and other events closely to assess their true impact on economic growth and corporate earnings. We continue to invest with confidence, rebalancing portfolio weightings and ensuring that individual portfolios are appropriately diversified, according to each client’s risk profile, while also looking out for potential opportunities that indiscriminate sell-offs often provide.