This week’s emergency dose of monetary medicine from the Federal Reserve is a clear health warning for equity and credit investors. As some quipped after the US central bank abruptly sliced borrowing costs on Tuesday, a rate cut does not inoculate portfolios from the threat of deeper economic and market turmoil.
The Fed deployed a similar playbook in 2008 and 2001 — years that were distinguished by frenetic bouts of market volatility. And there were many false dawns during those periods before asset prices stabilised and began recovering.
Because of the coronavirus outbreak, investors face a decidedly opaque outlook for economic activity and corporate profits over coming months. The severity of the outbreak could lessen during the spring — or an increasingly uncomfortable environment may emerge, similar to late 2007 and early 2008, when the magnitude of the financial crisis slowly became apparent.
These scenarios are illustrated to some extent by the contrast between government bond yields and broad equity benchmarks. Amid all the market noise, equities have been relatively resilient, wiping away just the past few months’ gains, implying little more than a short-term blow for corporate profits. Should the coronavirus fade relatively quickly, the combination of a weaker US dollar and lower bond yields — prompting fiscal spending around the world — could feed a recovery in economic activity and asset prices.
That helps explain the correction in the FTSE All-World index, which from peak to trough in recent weeks is around 14 per cent. Declines in the region of 20 per cent to 30 per cent for broad equity markets are the hallmarks of a deeper economic contraction in the offing. This kind of drop has already been seen in US and European bank shares in recent weeks.
But the really dark signals are coming from the bond market, where the 10-year Treasury note is yielding well below 1 per cent — and a long away adrift of the current overnight mid-rate of 1.125 per cent set by the Fed. Look at real yields too, which are a guide to future growth expectations. The 10-year real yield has collapsed, nearing minus 0.6 per cent on Thursday. That suggests a deflationary shock, which is hardly good news for the economy or for corporate profits.
In that light, it seems too much to expect that coronavirus disruption will be limited. More economists are forecasting weak activity beyond the current quarter, as quarantines and restrictions curtail activity. Estimates of global growth this year are falling towards 2.5 per cent, a level that leaves little wriggle room for an extended economic shock. The Institute of International Finance notes that under its worst-case scenario, global growth could approach 1 per cent, down from 2.6 per cent last year and the weakest since the global financial crisis.
So this week’s action from the Fed, along with easing from central banks in Canada and Australia, reflects efforts to get ahead of tightening financial conditions. The release of the Fed’s latest Beige Book survey on Wednesday revealed supply chain disruptions and indicated that travel and tourism were already suffering late last month. It is therefore becoming harder to downplay the prospect of a bumpier outcome.
“The Fed is attempting to forestall this process long enough so when the real data finally catches up with the present dismal sentiment in risk assets, investors will have moved on to trading the stimulative and reflationary implications,” said Ian Lyngen at BMO Capital Markets.
One particular problem could be a liquidity crunch, as small and medium-sized businesses struggle to obtain new funding. The big rise in debt over the past decade has been focused among non-financial companies, which are now facing disruption that threatens their ability to service and refinance those borrowings.
Analysts at Jefferies believe rollover risks “will ultimately determine whether global equities escape from Covid-19 with a mild slowdown in earnings growth”.
Long-term investors should do as they always do: look beyond bouts of market volatility and wait for opportunities to buy high-quality companies at a nice discount.
But given the high starting point of valuations in both equity and credit markets, there is clearly scope for new lows before any clarity arrives. Dhaval Joshi at BCA Research estimates that the recent drop in equities means they are priced for an economic downturn lasting three months.
Investors with a longer timeframe of six to 12 months have yet to capitulate, it seems, which makes sense, given efforts to contain the virus that could limit its economic damage. But it is ominous that during the financial crisis, while some investors had capitulated by early September 2008, the bottom in stocks came about six months later.
Mr Joshi said investors should bear that in mind. “Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated equals the length of the downturn,” he said.
