Sharp falls in equity markets are never pleasant for investors, but the recent market weakness needs to be viewed in context of last year’s market environment, where we saw one of the strongest rallies in global equities in recent times. To illustrate, the US stock market (S&P 500) returned 31.5% in US Dollar terms last year, a performance which has only been surpassed once in the previous twenty years.
The driver of this performance was not better economic growth or corporate earnings delivery (both have been a little disappointing over the last year), but rather a re-rating of equity markets reflecting interest rate cuts from the US central bank, the Federal Reserve, and a material easing of US-China trade tensions. These two key developments allowed investors to look ahead to this year with more optimism and, as a result, pay a higher price for the future earnings stream afforded by equity markets.
With equities entering this year in more expensive territory, we gave guidance that investment returns were likely to be much more modest this year, even if the long-awaited pickup in economic growth and corporate earnings began to materialise. We also cautioned that higher starting valuations afforded investors less margin of safety to an external market shock – and it is against this background that the economic and financial market impact of the spread of the novel Coronavirus needs to be considered.
The initial assumption that the virus would be contained before reaching pandemic proportions is being challenged by recent news flow and, rather than representing a recoverable hit to firstquarter growth and earnings, market participants are factoring in a more prolonged period of disruption to global supply chains, factory output and consumer spending.
Despite the prospects for further monetary policy easing and a general (albeit modest) loosening of fiscal policy around the globe, this background of rising uncertainty has prompted some investors to bank part of the exceptional profits from the recent market rally. In the short term, equity markets may well have further to adjust as there is no evidence that the global spread of the virus is being contained.
However, we would also caution against the assumption that the eleven-year unbroken global economic expansion is about to come to an end and, with it, a much more savage market correction. Yes, first-quarter growth will be weak, but this is expected by markets. Furthermore, and as we have argued in the past, economic expansions generally end due to overheating, either in the real economy (which causes central banks to hike interest rates too rapidly) or in financial markets (where over exuberance pushes equity markets into bubble territory).
We are not convinced that either of these conditions has been met and maintain our base view that this year will be characterised by sluggish, sub-par growth, increasingly supported by looser monetary and fiscal policy.
Long-term investors who share our muddle through growth outlook should be mindful of the cheapness of equities versus sovereign bonds, particularly in the UK, where the so-called dividend yield gap is at its widest for one hundred years. However, those investors keen to deploy fresh cash to the market are likely to have the luxury of waiting for better entry levels as the news flow around the Coronavirus evolves further.
The above article was previously published by Charles Stanley on 26th February 2020