COVID-19-induced turmoil has sent markets on a roller-coaster ride since February. The initial pace of the downturn in the current bear market was much more rapid than in all other bear markets since 1960, and the subsequent recovery since 23 March has been one of the fastest on record.
Despite the stock market rally in July, we believe a disconnect remains between the rebound and the deep economic impacts of the coronavirus pandemic. Forward analysis is extremely difficult at this point, but a sharp decrease in economic activity is expected through Q3 2020 and possibly longer. For its part, the International Monetary Fund predicts the recession could be as deep as -3 per cent of global GDP this year.
In response to the crisis, central banks and governments globally have injected a huge amount of monetary and fiscal stimulus into the global economy in the past two months – amounting to US$15.86 trillion or 8.8 per cent of global GDP. The key question on everyone’s lips therefore is what kind of recovery this will conjure and what impact will that have on markets.
A lot will hinge on the points at which different countries reach the peak of new COVID-19 cases. Slow and steady progress is being made around the world, but we think the situation could rapidly change and force further disruption if and when spikes in new cases manifest. We believe the hurdle for country-wide lockdowns is high and measures to contain new spikes will be kept at a local level thanks to improved testing and tracing capabilities.
Thus, at this point, the data on the spread of the virus globally is not sufficient to confidently predict how long it will take for economic activity to return to normal. However, the length of the expected recession will be a key determinant of the ultimate impact on corporate fundamentals and earnings.
What is clear from the research though is that life as we knew it before the crisis will not be coming back anytime soon and not in the same way. Instead of looking at a return to normality in a few months, it is more likely to be in one year, and what life will look like on the other side will be more akin to a “new normal”.
The continuing divergence in equity markets is an indicator that market participants do not anticipate a great rebound in economic activity on the horizon. Thus far, areas of the market that performed the best leading into the sell-off also outperformed during the sell-off. Growth led value on the back of concerns about businesses with higher leverage and higher sensitivity to economic growth. Coupled with very accommodative monetary policy, it is clear that expectations are for a prolonged period of low economic growth and a low-yield environment. While we have seen some rebound in cyclicals, this is likely to be short-lived in our opinion. We believe the one cyclical segment of the market which could see a sustained rally during the recovery stage would be small caps.
Positioning for this environment
Despite this uncertain environment, we expect that massive fiscal and monetary support could set the stage for compelling valuations and attractive risk/reward over the medium to long-term in stocks once the virus is contained and the economy rebounds. We believe among those that could benefit are small caps, which will benefit when the cyclical outlook improves.
For a historical perspective, after the global financial crisis – when stocks in the financial sector were weighed down by both low rates and increased regulation while technology stocks benefited from the initial stages of online adoption – small caps outperformed, benefiting from their balanced sector exposure. Therefore, as the US economy rebounds from recession, we believe that small-cap equities may offer opportunities for upside potential. However, by the same token they could be vulnerable the longer the economy remains shutters.
In credit, yields rose dramatically after the sell-off, with high yield bonds and bank loans yielding more than 10 per cent at the peak of the crisis. In our view, maintaining a prudent allocation to these sectors makes sense for patient, long-term investors.
With an active approach and long-term investment horizon, investors will be able to pick the winners from the losers and add discriminately to riskier assets such as equities and high yield in this potential period of prolonged uncertainty.
Thomas Poullaouec, head of multi-asset solutions APAC, T. Rowe Price