The first phase of the market correction has been completed as we learn how to cope with the virus. The next phase will be about processing the economic consequences of the shutdown.
It seems we may at last have glimpsed a flicker of light at the end of what is still set to be a very long tunnel.
Italy’s coronavirus deaths appear to have reached a peak, demonstrating that the country’s national shutdown has been effective in bringing the transmission rate down to 1 (i.e. each infected person only passes the virus on to one other person rather than multiple people).
This gives us a roadmap to use in the rest of Europe and suggests that we may be coming to the end of the first phase of the market’s reaction to coronavirus. This first phase saw dramatic sell-offs all around the world as investors grappled with the uncertainty posed by the novel virus and valuations adjusted to more realistic levels.
The next phase is likely to see volatility subside thanks to the intervention of the authorities but investors now need to assess the economic implications of the various national shutdowns. Valuations are now down to a level which is consistent with a short technical recession, which is when an economy contracts for two quarters in a row. The question is whether the recession could be more protracted than this.
Firstly, growth was anaemic coming into this crisis. We compared the recovery last year to a “wobbly bicycle” where any gust of wind could blow us off course and this virus has the potential to cause knock-on effects. On the positive side, measures implemented by the various governments are likely to contain the potential for bad debts to pile up, although the extent of the safety net varies between countries. Crucially, workers have to be kept on the payroll because it takes time for companies to hire people back and this would slow the recovery.
The risk is also that we have “rolling shutdowns”, with the potential for activity to be impacted in the fourth quarter as we head into the winter. Infection rates in Australia also suggest that we can’t be relaxed about warmer weather improving outcomes.
Furthermore, we’ve not really seen the corporate impact of the virus yet; valuations suggest a fairly flat outcome for corporate earnings this year. I think the market still has to price in a more negative outlook for earnings.
Considering these risks, I would avoid those areas of the market most sensitive to the economic cycle and remain focused on quality.
I still see bonds as an effective hedge in an environment of uncertain growth. I believe there is some value in investment grade corporate bonds, but would favour the higher quality areas.
I’m more cautious on non investment-grade (high yield) debt at the moment because the impact of the shutdown has not necessarily been fully priced in the retail sector. A lot of the weakness in high yield this year has been a result of oil prices, which is another issue altogether.
When the Allied forces won “The Battle of Egypt” in 1942, Winston Churchill famously said: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning”. It’s possible that we’re reaching a similar turning point in dealing with the coronavirus in Europe. The market still has to absorb a very significant shock to demand, however, so we remain cautious.
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