Closing the book on a testing January

January is ending with some notable scores on the board for a number of important markets. The coronavirus has triggered substantial shifts in several asset classes in the past week, with even US large-cap shares now joining the global equity sell-off.

The fallout from the coronavirus has largely focused on China with global companies and sectors exposed to the region enduring hefty selling pressure. Until, today, US equities, courtesy of some big tech earnings powering past expectations (Amazon, Microsoft and Apple this week) had appeared resilient, helping Wall Street extend its long run of outperforming global rivals. 

That remains the case as the month ends, but Wall Street has been hit hard ahead of the weekend and this may well represent a wake-up call for investors.

Matt King at Citi writes:

“Markets struggle to deal with ‘tail risks’, and are prone to repricing abruptly when these suddenly become central scenario.”

He adds: 

“While history suggests markets will eventually rebound quickly once the incidence of new cases subsides, the risk-reward seems to have deteriorated significantly in the meantime.”

As it stands, areas of emerging markets have felt the burn from China’s health crisis. The Hang Seng China Enterprises index — which tracks mainland Chinese companies listed in Hong Kong — has fallen 6.7 per cent this week (down 8.3 per cent in January), its steepest decline since February 2018. That decline signals what to expect when equity markets in Shanghai and Shenzhen are set to open next week after an extended lunar new-year holiday. 

Subtract the S&P 500 from global equities and the January score for the FTSE All-World index is a drop of about 3 per cent. Add Wall Street into the mix and the All-World is off some 0.7 per cent for the month. That 24 per cent weighting of the tech sector in the S&P 500 takes some beating.

Judging by the steep slide in the price of copper, there is a case that this commodity has been used as a proxy for selling “China risk” by investors. Indeed, metals, oil and government bonds have experienced the greatest reaction to the coronavirus, suggesting a degree of “proxy hedging” that may well have pushed these markets too far. This is also highlighted by how an index of 20+ year Treasury debt has generated a total return of 6.7 per cent this month (as of Thursday). Such exposure does help offset declines in the equities for broadly diversified portfolios. And with Wall Street slumping on Friday, the 30-year Treasury yield dipped below 2 per cent (the first time since October), pushing total returns for the sector higher.

All told, since January 20 Brent crude oil has fallen 10 per cent, copper has dropped 12 per cent and the 10-year US Treasury yield is some 25 basis points lower. Among emerging market currencies the commodity players — Chile (very much a copper proxy), Russia and South Africa — have led the “carry trade” washout to date. South Korea, Malaysia and Singapore have also seen currency pressure given their trade links with China, so the direction of travel for the renminbi next week is shaping up to play a key role for EM currency sentiment. 

The current market reaction chimes with the recession fears of last summer, but as Jonas Goltermann at Capital Economics notes:

“To the extent that the virus outbreak, like the escalation of the trade war last year, threatens to damage China’s economy and undermine global growth, it makes sense that investors have reacted in a similar way. But a key difference between now and mid-2019 is that back then the global economy was already slowing markedly. In contrast, forward-looking indicators now point to the economy turning the corner.”

Concern about a China growth shock is clearly driving commodities and government bonds, whereas the lack of a substantial washout for broader equity markets — at least yet — appears to reflect investors waiting to buy the dip. Low bond yields only help reinforce this mindset as the 10-year Treasury yield loiters south of the S&P 500’s average dividend yield of 1.8 per cent. The 57 companies that comprise the S&P 500’s Dividend Aristocrats index produce a 12-month trailing dividend of 2.38 per cent. 

Also of note is the prospect of more stimulus from Beijing once the virus is under control. 

Mark Dowding at BlueBay Asset Management notes: 

“A weaker picture for China could be more negative for Europe and emerging economies in 2020. However, we expect that fiscal stimulus in China and Europe should help to offset this.”

Strategists at Citi Private Bank also highlight this aspect about market positioning at the moment.

“Those waiting on the sidelines for a market collapse — unwilling to align their asset allocation with their goals until they time the market just right — remain a potentially potent buying force. This is after investors pulled roughly $250 billion from equity funds last year even as markets rallied.”

One striking aspect of the market performance during January has been the steady retreat in bond yields. This was under way before the coronavirus emerged, but the ensuing demand for haven assets and the risk of a China growth shock has duly pulled long-term yields a lot lower as the month ends. 

This does leave long-dated bonds looking vulnerable if the global macro environment improves in the coming months. But what caps a big rise in bond yields is the lack of inflation pressure, as measured by central banks, and a sustained bounce in capital expenditures. The latest miss on revenues and Friday’s downbeat guidance from Caterpillar underscores the point made by this week’s fourth-quarter read on the US economy: a lack of capex. 

As BNY Mellon highlights: 

“Longer term, weak investment portends negatively for potential growth. This is one reason why real interest rates around the world have been so low and why yield curves are flat. Borrowing short term to reap greater rewards in the long term is at the core of capital budgeting, and such low real rates in the risk-free government bond market reflect in large part the market’s guesstimate of the expected return on private capital. If it were higher, real rates would be higher.”

Here, BNY breaks out the major sub components of gross private fixed investment from the final quarter of 2019, where only intellectual property and housing were positive. 

“Equipment — the intermediate goods used by firms in production — has fallen in three out of the last four quarters, and the only positive quarter during that stretch recorded a paltry 0.8%.”

Quick Hits — What’s on the markets radar

Finally, Friday night brings down the curtain on the UK’s 47-year membership of the EU. There is a little more optimism about the future and for UK assets from here, but negotiating a new trade relationship with Europe is the big challenge ahead. Via the FT Graphics team, here’s a look at the Brexit years in charts — from Irish passports to the value of the pound. I will only add that hearing a busker strumming Ode to Joy in Bank Tube station this morning was a sombre moment.

Source: Economy - ft.com