The coronavirus is weighing on investor sentiment again. Safe haven assets such as gold and US Treasuries are receiving a bid while global markets have taken a step back. Throughout February, investors had seemed to look past the coronavirus, hoping or believing the global economic impact would be transitory. The growth in new virus cases showed tentative signs of slowing and appeared mostly contained within China. Over the past week, however, new cases of the coronavirus are popping up outside of China, such as in Italy, Japan, South Korea, Singapore and Iran (though the number of cases outside of China is still relatively small).
There remains a large degree of uncertainty surrounding the virus, and no one knows how this will ultimately play out. There is already a clear human tragedy to the victims and their families. From an economic perspective, this uncertainty places the expected modest uptick in global growth for 2020 at risk. From a market perspective, investors always invest with uncertainty, and the carousel of concerns continues. However, with stock prices and valuations still near cycle highs, the risk of a worsening virus outbreak has not been priced into the market to a great extent.
This was part of the rationale behind the downgrade of our equity view to neutral at the end of January. Even before the virus outbreak, markets were vulnerable to unexpected bad news. Stocks had gone about six months without a pullback, investor sentiment had become stretched, and the S&P 500 was trading close to a 19x forward price-to-earnings valuation, a cycle high. The coronavirus added another layer of risks. With global markets still only trading a few percent below a record high, we continue to view the short-term risk/reward as more mixed, with equal downside potential, if not more, relative to upside potential.
That said, we are still viewing this setback within the context of an ongoing bull market, which eventually should provide a better buying opportunity. Investors should also not overlook supports that we anticipate will serve to buffer the downside. China is increasing its fiscal and monetary stimulus to help offset the slowdown—economic growth needs to be strong in the second half of the year (knowing the first half will be marked down) to reach the goal set in 2010 to double the size of the economy by 2020. Thus, more stimulus is likely. Also, the lagged impact of aggressive central bank interest rate cuts seen over the back half of 2019 should help cushion the downside. Still, global growth is set to be more muted near term.
The US economy will likely also be affected, but based on the current backdrop, recession risk still appears relatively low. Trade may slow, and there will likely be some impact to supply chains. However, this drag will be partially offset by a sharp drop in interest rates and energy prices. This should bolster the US consumer, which still represents about 70% of the economy.
Notably, just last week, two leading indicators that tend to peak well before a recession posted strong numbers. First, the Conference Board’s Leading Economic Index (LEI) reached a cycle high. The LEI—comprised of 10 important indicators including unemployment claims, credit, manufacturing activity, and the stock market—has historically peaked, on average, more than a year before recession. Secondly, housing, which tends to be a long leading indicator of the economy, remains strong. US housing permits numbers jumped to near a 13-year high last week, and housing starts remain near a cycle high. Housing starts have peaked well ahead of every recession in the modern era.
From a market perspective, equity valuations are rich on an absolute basis, a pickup in earnings growth is less assured given the weaker global economic backdrop and technical price trends are mixed. US markets are still trading above where they closed 2019. Thus, it is too early to say a buying opportunity has developed. That said, with the 10-year US Treasury bond yield back below 1.4%, the percentage of S&P 500 stocks with dividend yields above that level has climbed above 60% compared to a 30-year average of 18%. This should help cushion the downside so long as a US recession does not become the base case assumption. This is important insofar as stocks have risen about 85% of the time outside of recession on a one-year basis.
Bottom Line & Positioning
We continue to view the short-term risk/reward in stocks as mixed, with equal downside potential, if not more, relative to upside potential. Thus, for investors with equity allocations which have moved well above targets with the run up in stocks, we still think it makes sense to trim positions back toward targets as discussed earlier this month. Conversely, for investors with excess cash, we would look to average into the market over time and be more aggressive should a deeper pullback develop given we maintain a favorable longer-term outlook.
From a positioning standpoint, we still favor US large caps, which should continue to hold up better than most parts of the globe. We stay focused on high quality fixed income and, where appropriate, alternative strategies that have less directional market exposure, which should provide ballast to portfolios during this period of heightened uncertainty.
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