U.S. equities suffered a significant selloff on Thursday, with the S&P 500 down 4.4%, and 12% lower since the end of last week. This puts U.S. equities in correction territory along with Australian, Japanese and Korean markets.
The correction was triggered by market concerns that the spread of the COVID-19 virus outside of China was gathering pace, possibly leading to significant damage to the global economy as the crisis morphs from a Chinese epidemic to a potential global pandemic.
While the virus has been concentrated in China since late January, the number of new cases in other countries has risen considerably, e.g. South Korea and Italy. Meanwhile, the virus is infecting a larger number of countries, even if it is only a few cases have been reported, reaching the Middle East (especially Iran) and South America, leading to fears that it will be labelled as a global pandemic.
The market concern is perhaps not the actual spread of the virus itself but the official response to its presence in new locations. Compared to prior episodes of viral contamination, officials have reacted aggressively to contain COVID-19, potentially deepening the economic impact. The more countries that are faced with combating the illness, the wider the potential for economic disruption and possible increase in recessionary risks.
Investors are comparing the economic costs to China from the outbreak, such as reduced consumption and disruptions to manufacturing, to what could potentially happen in the U.S. or Europe if the number of reported cases were to rise significantly. This could create considerable pressure on corporate earnings with both a decline in revenue and contraction in profit margins. This has triggered significant risk aversion as investors rotate from risky assets to safe haven assets, such as U.S. Treasuries (UST). The yield on the 10-year UST had fallen to 1.26% and the 30-year yield fell to a historical low of 1.76% at the time of writing.
Expectations of policy rate cuts by the Federal Reserve (Fed) have also risen. The futures market is currently pricing in an almost 90% chance of a 25bps rate cut at the March 18 meeting. Given the fast moving nature of the outbreak, the Fed may not have sufficient hard data or clear evidence to support a rate cut so soon. Yet, it probably needs to sooth market anxiety by offering to act promptly if conditions worsen.
The pace of the market correction has been extremely swift in historical terms. The S&P 500 has fallen the required 10% to be a correction in just six days (Exhibit 1,). It is worth noting, however, that U.S. equities were close to record highs just a few weeks ago and valuations elevated. Investors had justified higher valuations based on expected stronger earnings growth in the year ahead and the low rate environment. This assumption on earnings growth is severely challenged by concerns of the COVID-19 outbreak.
EXHIBIT 1: Historical corrections in the S&P 500 Index
Source: Deutsche Bank Securities, FactSet, J.P. Morgan Asset Management.
Investment implications
In our view, market sentiment is likely to remain very cautious in the near term, as investors wait for clarity on just how far and wide the virus may spread. As we observed with Asian markets in recent weeks, especially China and Hong Kong, sentiment may stabilize again once the rate of increase in the number of new infections starts to slow.
In this environment, investors should remember the defensive role that income offers in a portfolio. Investors can seek yield in emerging market debt and high quality corporate credits. The decline in risk-free rates (UST yields) makes adding duration an expensive proposition at this juncture, but should offer a potential widening of credit spreads in these instruments. In equities, while markets are suffering heavy losses, a lot of sector rotation is occurring within indices. Investors could consider sectors that should be more resilient to an extended outbreak, such as healthcare, consumer staples and utilities. It may be prudent to have a little more dry powder available to take advantage of any potential recovery in markets, if the feared loss in economic output does not materialize.
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