An exogenous shock spoiled the party


By Alexander Roose, CIO Fundamental Equity

Just when trade worries were slowly put to rest and as equity flows had turned positive since the end of 2019, an exogenous shock spoiled the party. As the daily number of COVID-19 cases started to jump outside China (see below), panic took hold of equity markets in the second half of February, with daily corrections the likes of which we had not seen since the Great Financial Crisis (GFC).

COVID-19 – Number of cumulative cases and mortality rate (outside China)

Source: World Health Organization. Note: Figures include cases in HK, Macau, and Taiwan

For instance, last Friday (28/02), more than USD100bn was traded on the S&P 500 ETF, while the volatility index jumped to above 40, dwarfing the level last seen at end 2018 (see graph below) and indicating capitulation levels. Equity drawdowns greater than 15% are rare outside a prolonged economic contraction. And so far, there is little reason to expect that the coronavirus will push the US economy into a recession.

Source: Bloomberg

As there is no historical reference framework for the coronavirus (typical of a “black swan” event), it is difficult to assess the impact of the outbreak, how long it will last and how effective measures taken to contain it will ultimately be. Companies across the globe have issued profit warnings due to the impact of the virus, but very few have been able to quantify the impact beyond the next quarter. When looking at past exogenous shocks however, we see that economic disruption can be sizeable, but is usually short-lived. China’s manufacturing PMI in February dropped below 36 (lower than during the GFC), demonstrating the extreme impact of the outbreak, but the A-shares market shrugged off this bad print as daily infections in China have peaked and liquidity measures have been implemented. Year-to-date, that market has recouped all its losses. For equity markets in developed countries, we expect nervousness to continue as long as infections have not peaked and as the crisis could last longer than in China because it is more difficult to lock down entire cities in those countries. Continued beta de-risking from systematic strategies could also fuel high-level volatility.

Looking beyond the next couple of months, as long-term investors, we are ready to add to our investments in “qualitative companies that are able to grow their top line through the cycle, have competitive advantages, relatively low leverage, low vulnerability to disruptive forces and are ideally able to capitalize on the United Nations’ Sustainable Development Goals.” Interestingly, these companies have held their own in this recent market rout. Last but not least, we would like to underscore the fact that the yield gap (global dividend yield – US 10-year yield) is close to 2%, a level last seen in 2009 and 2011. Historically, this level has turned out to be an important valuation support and coincided with a turnaround point for equity returns (after at least a bit over two months).

Yield gap only higher in March 2009

Source: Bloomberg, Exane BNP Paribas estimates


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