Volatility will ease when recovery measures are in place

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Global equities have suffered a sharp correction over the tumultuous past week with most global markets down by more than 15%, or levels not seen since the financial crisis in 2008 due to growing alarm over the coronavirus (Covid-19) which was finally declared a pandemic by the World Health Organization (WHO).

While the number of cases in Asia such as China and South Korea have fallen sharply, those in other parts of the world – notably Italy and Iran – have surged with fears of further escalation in other parts of Europe and particularly the US where the number of people being tested have been sorely lagging behind the rest of the world.

The upshot of these developments have been growing concerns over how the spread can be contained as well as how global policymakers will apply both monetary and fiscal tools to mitigate the economic fallout that has already crippled supply chains and devastated sectors such as retail, aviation and tourism.

Our assessment of the situation is that systematic trading had probably played a role in triggering sharper than warranted drawdowns from the ripple effects of Covid-19. In recent years, we have seen a higher percentage of the market driven by volatility due to the focus on risk parity and momentum strategies that can trigger outsized reactions when markets turn risk off.

Several measures we track are signalling that markets are increasingly oversold. The put/call ratio has surpassed its 95% percentile (10-day moving average) with the percentage of stocks hitting 3-month lows at 76%, a level that had only been breached four times since 2008. Valuations of global equity markets have come down to average levels with the PE ratio in the US dropping from 19x to 16.5x.

On a risk premium basis adjusted for the risk-free rate, global equities are over one standard deviation (SD) more attractive than usual. For the S&P500, 45% of stocks have fallen by 20% and a historic high 75% of stocks have a higher dividend yield than 10-year US Treasuries.

We remained concerned over the economic impact of Covid-19. Our base case remains that the global economy will slow significantly in 2Q20 amid the preventive measures taken to arrest the spread of the virus, with the likelihood of a second-half recovery.

Meanwhile, the success of containment strategies by China, South Korea and other parts of Asia has been encouraging examples for the rest of the world. South Korea in particular has been able to bring its number of new cases down from over 2,000 per day to 518 as of 5 March and progressively lowering by about a 100 per day to 165 on 9 March with a fatality rate below 1%. China has seen new cases declined sharply from the thousands at its peak in January to the single digits with reports of Chinese factories gradually resuming normal production.

Additionally, there have been substantial global policy responses. Central banks around the world have been easing their monetary policies with the US Fed leading the way with a 50bp cut in interest rates on 2 March. We expect the Fed to cut another 50bp at the FOMC meeting on 18 March. It is also increasingly likely that Washington will be following up with wide-ranging fiscal policies including economic relief for companies and workers despite this week’s hiccups in messaging to shore up market confidence.

The sharp falls this week has put an end to an 11-year bull run, the longest on record. Thus, the current cycle can be deemed as extended and due for a late-stage correction.

Hopefully, we will be able to see the successes in controlling the spread of the virus replicated in Europe and the US. The weeks ahead will likely remain choppy for global markets, but with the possibility of drop-offs in the number of new cases as more preventive measures are put in place, there is still the basis of a good case for a second-half rebound.