Opportunities amid COVID-19 sell-off

by Chief Investment Office 28 Feb 2020

Thought of the day

Risk assets have continued to fall amid mounting concern over the global spread of COVID-19 outside of China. S&P 500 futures pointed to a 1.3% fall at the open for Wall Street, after a 4.4% decline on 27 February, the biggest one-day decline since 2011.

The Stoxx Europe 600 traded down 3.9% on Friday, after a similar fall on the prior trading day. Both European and US markets have now lost more than 10% since worries over the virus intensified last week. Asia risk assets sold down Friday as well, with Japan's Nikkei 225 (–3.7%), the South Korean KOSPI (–3.3%), and onshore China (CSI 300 –3.6%) all retreating. Investors continue to seek safety in US Treasuries, with the yield on 10-year bonds falling as much as 14 basis points to 1.155%, an intra-session record low.

The move reflected a further accumulation of negative news over the global spread of the infection. The US Centers for Disease Control and Prevention confirmed an infection in California that could not be traced to another country. Cases in South Korea have continued to rise, now hitting 1,766 from around 30 at the start of last week. Japanese Prime Minister Shinzo Abe said the nation's schools would be closed until April, and French President Emmanuel Macron warned that an epidemic in his country was inevitable. Therefore, investors are starting to react to tomorrow's inevitable headline that cases of the virus are expanding outside of China. Furthermore, technical selling is playing a role in exacerbating market moves. With the S&P 500 now having traded through its 50-, 100-, and 200-day moving averages, we could see continued volatility driven by forced selling in the week to come.

Putting the human tragedy of these infections to one side, the market is still uncertain how to price the rapid increase in infection rates versus the low absolute number of cases outside of China. The US has just 60 confirmed cases, for example, Germany 27, France 18, and the UK 16—and we don't think major economies are going to be shut down over 100 or 1,000 cases of coronavirus. However, the fear of contagion outside of China has now led to a rapid market correction and significant cuts to growth estimates.

What lessons do we draw on from our disaster playbook?

While every case is different, history shows that once a disaster hits and markets sell off, investors may make reasonable projections about the initial growth slump, but tend to be bad at pricing in how quickly growth can recover. For example, in Japan's 2011 Fukushima disaster, the consensus expectation for third-quarter GDP was 1.6% annualized. In reality, it came in at just over 10%. To be sure, while we cannot say exactly when the coronavirus uncertainty will peak, we think many of the conditions that can allow for a rapid recovery are in place. Currently, we don't see significant financial system distress, and further stimulus is already being deployed in some parts of the world. And though volatility has picked up, historically when the VIX index is over 25 and bank lending standards remain loose, US equity market returns over the next six months have been over 15%.

Where are the opportunities today?

1. Prefer EM to DM equities

Emerging market stocks have begun to outperform developed market stocks in recent days, as a result of greater evidence of successful containment in China (just 391 new cases were reported in China ex-Hubei in the past week), and growing fears about the virus spreading in Europe and the US. As of end-Thursday, emerging market stocks have outperformed developed markets by 1.7% since the beginning of February, and 2% in the past week. We expect this trend to continue and are overweight EM equities, with a particular preference for China within emerging markets. We are more cautious on the Eurozone.

Our positioning is based on our view that China will continue to succeed in containing the outbreak, allowing the economic and market impact from COVID-19 to be largely confined to the first quarter of the year. We note that high frequency indicators like daily coal consumption and workday traffic indexes are showing that activity is starting to recover. Assuming this proves to be the case, we expect earnings growth of near 12% in Asia ex-Japan this year.

We also view valuations in Asia ex-Japan as reasonable at 1.6 times book value, a near 35% discount to global peers. Meanwhile, the forward P/E discount of EM equities to developed market equities increased recently to 28%, above five- and 10-year averages. In contrast, the Eurozone market is trading on a 12-month forward P/E ratio of 14.9 times, at the upper end of the 15-year range, at a time when we expect earnings to contract 1% in 2020.

2. Buy oversold sectors

We highlight a number of sectors that we think have now been oversold:

  • US consumer discretionary. Stocks overall are down 10% in the last five trading days, in line with the market, despite strong housing data and results from Home Depot, steady labor markets, and a significant drop in mortgage rates, which should help support the consumer in the months ahead. Average US 30-year mortgage rates have fallen from 3.86% to 3.66% since the start of the year. E-commerce retailers could even benefit if consumers are forced to spend more time at home.
  • US communication services. The sector is composed of large-cap digital advertising platforms, media (including digital media) companies, and wireless service providers. Although digital advertising could see some marginal weakness, digital content providers (think streaming companies) are likely to prove to be more defensive, and potentially even beneficiaries of more time being spent at home.

3. Buy into long-term winners

The sell-off in equities offers investors opportunities to enter longer-term investment themes at discounted prices. The virus outbreak is likely to accelerate some of the key secular trends driving markets in the coming decade.

Digital transformation.The transition toward remote working has been given additional impetus, and engagement with online business models in China has increased significantly during the outbreak. We believe the confluence of 5G, big data, and artificial intelligence (AI) will be a major growth area in the decade ahead, and estimate spending on enabling technologies will grow from USD 526bn in 2019 to USD 1.1tr by 2025. AI-based software and 5G-related semiconductor firms are likely to be key beneficiaries, in our view.

Genetic therapies. The coronavirus has also demonstrated advances in genetic technologies, which are helping scientists identify how the virus spreads. During the 2002–03 SARS outbreak, it took US and Canadian scientists five months to complete the genome sequencing of the virus. This time Chinese scientists sequenced COVID-19 in about a month. In our view, genetic therapies could drive a paradigm shift in medicine. We recommend investing in genetic therapies through a diversified portfolio of companies in order to manage the risks of individual clinical failures.

Sustainable opportunities in EM. While the coronavirus will continue to dominate news headlines in the short term, investors should not forget about the longer-term secular opportunities offered, in part, by greater scrutiny placed on unsustainable practices. We see a compelling investment opportunity in emerging markets through incorporating environmental, social, and governance (ESG) factors. Although ESG regulation in emerging markets is often less robust than in developed markets, this also means investors are likely to place a greater premium on those EM companies with higher ESG standards. The MSCI EM ESG Leaders index outperformed the broader MSCI EM index by more than 3% annualized from inception at end-September 2007 to end-September 2019.

4. Enhance your yield and take advantage of higher volatility

Aside from the plunge in equity markets in recent days, the drop in 10-year US Treasury yields has been one of the most notable moves in global markets. Yields are now just above Thursday's record low of 1.24% on the 10-year, and the market is now pricing a 65% chance of a Fed rate cut at the March meeting.

Against this low yield backdrop, investors will need to consider strategies that can enhance the yield in portfolios. Our favored strategies right now include buying dividend-paying and quality stocks—we note that the gap between dividend yields and bond yields in Europe is currently close to a record high. We also view European bonds in the crossover zone between investment grade and high yield as potentially attractive.

The rise in volatility in recent days also means that investors can earn higher yields from strategies like put selling, which can enable investors to take advantage of higher volatility while offering a more defensive exposure to equities. Investors looking for further downside cushioning could also look to structured solutions which can enhance their yield while offering a degree of capital protection.

5. Get your portfolio fit to face the virus

Portfolios which are poorly diversified, either by asset class or by geography, are likely to see a bumpier ride in the weeks to come than those that are well diversified. The crisis has clearly shown the effectiveness of holding a mix of equities, bonds, and alternatives in a portfolio, with strong performance from bonds helping cushion declines in equities. Equally, global diversification has helped smooth performance as the virus has spread around the world, and remains prudent given the uncertainty about which regions will ultimately be worst affected. We also continue to see gold as an attractive portfolio hedge; in a pandemic scenario, we would expect to see gold prices rise to USD 1,700–1,800/oz.

Investors should view the initial phase of the outbreak as a stress test, and take the opportunity to get their portfolios prepared for future risks through asset class and global diversification.

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