The extreme turmoil in global financial markets continued unabated last week, with price volatility across equity, credit and bond markets several standard deviations above normal.
At one point, global equities were down by 17 percent, before rebounding strongly on Friday, but still ending the week deep in the red. Credit and bond markets experienced huge spread widening and rapidly deteriorating liquidity and wider bid-offer spreads.
This all happened despite the roll-out of monetary and fiscal policy stimuli around the world.
The reason for the extreme market movements and steep losses within risky assets is the rapidly rising risk of a global recession due to the coronavirus pandemic combined with a global oil price war. The extent of the losses has been exacerbated by the fact that most assets were expensively-priced and investors were heavily overweight in risky assets and very optimistic in their growth outlook up until mid-February.
The question all investors are asking now is whether it is time to buy risky assets again. Have we seen the worst? Is it time to buy the dip as many strategists from the banking sector have already announced with a surprisingly high degree of conviction? Or has the downturn in risky asset prices just begun?
For the long-term investor, it’s obvious that all risky assets, equities and investment grade, high yield bonds and emerging markets bonds, have become cheaper over the last month and that their long-term return outlook is, therefore, more attractive. Main equity indices have dropped 20-30 percent from the peak and spreads and yields on a lot of credit bonds have risen - by 3 percent or more on main high yield indices in the US and Europe.
However, given that most risky assets were expensively-priced before the corona pandemic catalyzed the current market downturn, valuation on large swaths of equity sectors and factors like US growth, low volatility and momentum stocks have dropped to neutral levels, at best.
The cyclically adjusted P/E of the total US stock market has dropped from a very high level of 35-36x to closer to 25x, though this is still high.
The same goes for AAA-rated corporate bonds where yield spreads to treasury bonds have risen, but the current nominal effective yield is more than 50 bps. lower than before the market turmoil erupted in mid-February.
The bottom line, however, is that the long-term investor can currently buy equities at attractive valuations within big parts of the Far Eastern markets like South Korea, China and Japan, as well as emerging markets and the value factor within Europe and US – even when a global recession and much lower earnings estimates are taken into consideration.
In the short-term, though, the market outlook remains shaky. When assessing the markets, the short-term investors will look at valuation, but mostly technical and fundamental parameters.
The technical picture is driven by positioning, flows, sentiment and the technical analysis picture, while fundamentals primarily cover the business cycle outlook and fiscal and monetary policy. Technically, many risky markets rebounded from extremely oversold conditions and at very important support lines on Friday. Investor sentiment has dived from extreme optimism into depression.
While most risky asset markets remain oversold, some technical support levels are close to being broken even after the Federal Reserve’s bazooka monetary easing policy was announced yesterday. If they hold, a further short-term bounce seems likely.
However, positioning data and fundamentals paint a less rosy picture.
Positioning data, although lagging the volatile market action, suggests many investors are far away from bombed out de-risking levels normally seen at sustainable market bottoms.
Furthermore, the business cycle outlook is rapidly deteriorating. Although news about the corona pandemic is improving in the Far East, the US has not reacted forcefully until recent days and their response will hit growth hard in the coming weeks.
Thus, we are very likely approaching or already in a global recession where earnings estimates will have to be lowered by at least 20 percent for the coming year and corporate default rates will surge significantly. This is the case even given the huge monetary and fiscal policy response seen in recent weeks. The bottom line is that the short-term market outlook remains shaky. The fight against the corona pandemic seems increasingly likely to hit the global economy for more than just a few months and be drawn out into the second half of 2020, which is not yet the consensus among investors and analysts.
Clear signs of containment of the coronavirus, even more forceful reactions from the authorities, especially regarding fiscal policy or signs of investors having totally de-risked their portfolios, are the signs to look out for to see a sustainable bottom on the markets. Until then, it’s going to be a bumpy and risky ride.
This post originally appeared on AM Watch.
