The coronavirus continues to make headlines with markets swinging wildly day by day as news hits the screens. This is our third update on the investment implications of the epidemic. Coronavirus is now having a global impact and causing significant share market volatility. There have been big falls in prices over the past week wiping trillions of dollars of value off the market followed by equally sharp bounces. Interest rates have fallen to historical lows.
The impact of the coronavirus on markets
Over the past week week the pendulum swung from greed to fear; from a very buoyant start to 2020 on global share markets, to falling in excess of 10%. A fall of more than 10% is commonly referred as a correction. According to data from Deutsche Bank Global research six days is the fastest correction in the S&P 500, the most recognised measure for the performance of the United States share market, on record. Ever.
At the same time the rush to embrace safe haven assets has meant interest rates have fallen towards all-time lows in almost every market around the world. In the United States 10 year treasury rates fell are now below 1%. That is an all-time low. New Zealand Government bond yields are hovering just above lows but look likely to head lower.
Is coronavirus the only reason causing the market's jitters?
Share markets have been very strong, not only in the early part of 2020, but have had a decade long bull market. While the underpinnings of the bull market were sound - strong and sustained earnings growth - even before the coronavirus cracks were beginning to appear. And it wasn’t just one crack.
The market’s apparent strength had been increasingly concentrated in a smaller and smaller group of mega sized winners. Names that we all know like Amazon, Google and Microsoft were almost solely responsible for driving the market higher; in fact up to its peak in February 68% of the US share market’s gain thus year was driven by just ten companies.
This same dynamic had pushed the valuation of shares towards peak prices, although still a long way below the infamous tech bubble of 2000.
An increasingly narrow market of few winners and many losers and extended valuations, creates a tinder dry environment, vulnerable to a spark. Coronavirus provided that spark and of course is already having far reaching consequences affecting both economic activity and company earnings. But its impact is amplified by the market environment that it spawned into.
How much bad news is now factored into share prices and what are we doing in portfolios?
No one knows exactly what will happen next, but understanding just how much downside is priced into markets helps give a sense of how the future might unfold. In the seven days to last Friday the US S&P 500 share market index shed $3.7 trillion dollars of value. To put that in context the entire productive capacity of the US economy, measured by GDP, was $21.7t last year. If coronavirus just has a one year affect the movement in market values suggest that the US economy could shrink by more than 10%. That seems unlikely, possible, but unlikely.
Of course that very simple maths is just that, too simplistic. If the economy did fall that much it would take a number of years to recover, but the general point is valid. The market has already factored in a material fall in economic activity.
Or has it? And that’s where the valuation picture going into the coronavirus epidemic complicates things. Part of the selloff is undoubtedly driven by a change in people’s risk perceptions and their enthusiasm to own highly priced shares into what will, at best, be softer economic growth, and at worst a recession. That might mean less economic damage is priced in than it appears.
Another way of looking at the outlook for shares is to consider returns against other asset classes.
One simple approach to do this is to compare the dividends shares pay against government interest rates. In practice that mirrors a decision that investor’s face in the real world. Where to put their money – in fixed income or in shares?
As of last night US Treasury bonds yield a paltry 1.0%pa for the next ten years. On the other hand the dividend yield, based admittedly on analyst forecasts for next year, for the US S&P 500 share market index is 2.0%, a full 1% above Treasuries.
This is unusual. For much of history dividend yields have been lower than government interest rates. In the recent past the only times dividend yields have approached anything like this premium to Treasuries it has been a good time to buy shares. Well at least in a relative sense.
Therein lies the rub. In this framework shares do look like interesting value but that is partly predicated on extraordinarily low interest rates. Future returns for both asset classes look muted, shares just less so given recent moves.
So while shares are more attractive than they were, we think patience is warranted.
In the short video below I delve further into what we are doing in our investment portfolios that hold multiple asset classes, like shares and fixed income. This includes our KiwiSaver Schemes.
What should you be doing?
Our guidance remains the same as last communication - for most of our clients, if you're in the right investment strategy for you then you should do nothing. I speak about this in more detail in the brief video below.
If you are worried and you think it is time to revisit your investment strategy then please get in touch with our team. We are here to help.