FLASH MARKET UPDATE, 10TH MARCH 2020
What Happened Overnight?
It was a dramatic trading session overnight. Coronavirus fears and a falling oil price fuelled an equity sell-off and a flight to safety. The FX markets have also reacted though much of the shift in sentiment last week has been experienced across equity markets.
Global share markets are a sea of red as investors attempt to quantify fears over the coronavirus spread and the breakdown of an OPEC deal which led to a sharp fall in oil prices. US equity bourses are suffering their largest falls since the GFC in volatile trading. The S&P 500 closed down ~7.6% and the Dow Jones is ~7.8% lower. Earlier in the session, circuit-breakers were triggered when the S&P 500 fell 7% shortly after opening. Following a 15 minute trading halt, shares fell further. All sectors suffered heavy losses, with the greatest falls in energy stocks and financials.
Demand for government bonds surged amid a flight to safety. The US 10-year treasury yield is down 14 basis points to a 0.57%. Fixed income trading was highly volatile. At one point, the US 10-year yield touched 0.32% before quickly recovering. The rest of the US yield curve was also lower. The 3-month and 2-year yields are both currently 0.4%.
Australian bond yields were also lower yesterday. The 10-year bond yield fell 7 basis points to 0.62% and the 3-year yield was down 1 basis point to 0.39%. Interest rate futures markets are pricing in a certain rate cut by the Reserve Bank (RBA)’s next board meeting in April.
The Australian dollar continued to hold its ground reasonably well, notwithstanding some extreme volatility at various points since the weekend. It is currently trading at around US$0.6583 but earlier yesterday fell to US$0.6313 before rebounding sharply. At one point, it was trading higher than its previous close.
For commodities, Oil prices continue to fall following the breakdown of an OPEC deal to cut crude production. Russia and Saudi Arabia appear to be digging in and preparing for an oil price war. On top of high production from major producers, the International Energy Agency (IEA) forecasts that demand for oil is poised to drop this year for the first time since 2009. WTI futures fell US$10.1 per barrel to US$31.1. Australia’s major commodity exports including iron ore and coal have so far avoided any major price declines. The price of iron ore remains in the mid-US$80s amid supply disruptions.
Implications now for the Outlook in 2020 and beyond based on what we know
Coming into 2020 the BT Investment team were mildly positive longer term for asset markets. The team saw a decrease in its 10-year expected return assumptions at the beginning of this year following such a strong year in 2019 for asset returns. However what was expected was positive equity risk premium with equities remaining relatively attractive compared to other asset classes. 2019 was also a period where very strong equity returns (+28.0%) for the US S&P 500 Index was accompanied by weak profit growth (earnings per share growth for the US was just 2.9% in 2019). This left the starting point for most equity markets near full to fair value with expectations for lower returns and a catch up in earnings growth to support our mildly positive outlook.
Additionally the US equity market finished 2019 at a risk premium to the 10-year US bond of around +2.5% which has now increased to +3.6% as at the end of February. These are relative levels not seen since the European debt crisis of 2011-2013. Further, after adjusting for the current market implied (e.g. -20%) fall in future company earnings, and given bond yields continue to hold at current levels, the US equity market would still be trading at a +2.6% equity risk premium. As a result it is difficult for longer term investors to fundamentally have a negative outlook for equity markets at such levels given Bonds are currently priced to return at best +1.0% p.a. over the next 10 years.
Portfolio Implications
As the BT Investment team considers the current market impacts of the COVID-19 and Oil price induced correction over the last few days, admittedly we do not know when or how the current outbreak may be contained, nor the outcome of the oil price shock. Equity markets have already priced in a significant adjustment down in growth and profit expectations yet historically events such as these have seen markets experience a recovery over the next 6 months.
Additionally the impacts of the latest outbreak have so far only impacted the global supply side whilst the incoming 2020 economic environment and fundamental backdrop (low interest rates and inflation, fiscal stimulus in China, robust demand in the US and potential for increased fiscal stimulus across other regions) still remains a positive and may yet provide even more support should governments and policy makers look to pre-empt a global growth slowdown from here. The current period of volatility could continue however markets have discounted significant underperformance with little consideration to any recovery in growth towards the end of this year.
How are the markets behaving?
It’s important to remember the interplay between risk, return and investment horizon. As depicted below (figure1.), there has been periods of market corrections as a result of geo-political and economic events.
Another way of looking at the interplay between market shocks (volatility) and the impact on short and longer term returns, is looking at the behaviour of a typical ‘Growth Fund, (85-90% growth assets), figure 2 below provides an example of the volatility in shorter term (1 month – 1 year) returns variances against the longer term (7 and 10 year) returns that show far greater consistency in rolling returns. Being that many investors make decisions to change their investment strategies based on shorter term events, it is imporatant to remember the benefit of time and why you chose your original strategy.
