It's the end. Now what?
Covid-19 has no recent precedence, but history can provide important insights
1 Apr 2020 | Daniel Yu
THE longest bull market in US history – 11 years – started on the 9th of March 2009. It ended on what some now call 2020’s Black Monday, coincidentally also the 9th of March.
 
Within minutes of the markets’ opening that day, circuit breakers were triggered, which halted trading by 15 minutes. By the end of the day, the Dow Jones Industrial Average (DJI) closed 7.79% down, or by 2,013 points. The market-wide circuit breakers, designed to halt a sharp, accelerated panic selling, was updated by the US Securities and Exchange Commission in 2013.
 
Such was the extent of investor anxiety it prompted the world’s biggest fund manager, Blackrock, with over US$7 trillion of assets under management at the end of 2019, to declare in bold: “This is not 2008”, the year Lehman Brothers collapsed at the height of what was to become the Great Recession in the US.
 
The fund manager acknowledges that the “virus shock’s impact will likely be large and sharp, but we believe investors should be level-headed, take a long-term perspective and stay invested. The economy is on more solid footing and, importantly, the financial system is much more robust than it was going into the crisis of 2008”.
 
Other asset managers similarly joined in. “The coronavirus outbreak and related shocks to the economy have unsettled financial markets in recent weeks, a situation now worsened by the inability of OPEC and its allies to agree on further production cuts,” opines Michael Strobaek, global chief investment officer at Credit Suisse. “Though the backdrop appears decidedly bleak, investors should be wary of taking sides and should not try to time the markets.”
 
DJI fell by another 10% on Thursday, the biggest single-day decline since Black Monday on October 19 1987. But by the end of the week, the DJI had recovered some of the losses. But it ended the week close to 20% down year-to-date. Similarly, the S&P500 is down 16.7% and the Nasdaq index is off by 13.3% since the start of the year. Indices across the world were similarly decimated from the FTSE 100 in the UK (-29.4%), Hang Seng in Hong Kong (-18.4%), and Japan’s Nikkei 225 (-24.8%) all falling by double digits.
 
Not surprising. A rush for safe-haven assets ensued. The 10-year US Treasury yield fell below 0.5% during that Monday for the first time, a new record low. The number of countries now with negative bond yields continued to grow with five-year UK yields trading below zero for the first time. The UK joins France, Germany, the Netherlands, Switzerland, Spain, Portugal, and Japan whose bonds are trading in negative territory.
 
Market dislocations
 
Another Swiss private bank, UBS, notes that the market has priced the US Fed cutting the Fed funds rate to zero by the end of the year, or 100bp (The following Monday, the Fed did cut by 100bp to a range of 0% and 0.25%). “Curves are flattening, which indicates some expectation that the Fed will relaunch QE,” the bank shares (The Fed also announced a US$700 billion bond purchase programme). “A flat yield curve and cash rates at or below zero are not a positive for the banking sector and could lead to fears about credit provision to the real economy. With credit markets currently closed to new issuance the only source of funding for corporations is currently banks and central banks.”
 
Blackrock believes this is a time for investors to keep a long-term perspective. “The ultimate depth and duration of the coronavirus’ economic impact are highly uncertain, but we still believe the shock should be temporary as the outbreak will eventually dissipate and economic activity will normalize – assuming the needed policy response is delivered.”
 
Adds UBS: “Given current reduced liquidity in a number of markets, investors should also be particularly cautious about taking rushed decisions in times of volatility, noting that bid-offer spreads in equities, and particularly in credit, are likely to be wider than normal at present.”
 
Market dislocations as extensive as what happened in March often present an opportunity to find value as assets go from overpriced to fairly priced, and even underpriced. But how to avoid catching the proverbial falling knife? Timing the moment is always tricky.
 
MSCI, the index provider, shares some insights from two of the recent sharp dislocations: in 2001 following the terror attacks on September 11; and the financial crisis of 2008. “In the two previous extreme events, the [US] equity market continued to decline over the following six to 12 months, suffering total drawdown in excess of 50%,” shares Dimitris Melas, managing director and global head of core equity research at the firm. “Also, in both 2001 and 2008, volatility continued to rise after the initial shock, peaking a few months before the market bottom.”
 
In 2001 equities were already smarting from the burst of the dotcom bubble. Following 9/11, the equity market continued to fall and experienced maximum drawdown of 52% one year later in October 2002, Melas writes. The market regained its previous peak five years later in July 2007, delivering a total return of 105% during this period.
 
In the case of 2008, he notes that the equity market also continued to decline in the months after, experiencing a maximum drawdown of 56% six months later in March 2009. It then took more than three years for the market to reach its previous high in September 2012, producing a return of 132% during this period.
 
So far, the Covid-19 pandemic and oil-price collapse have led to a near 20% drawdown in equity markets and a spike in forecast volatility to over 40%, he continues. “It remains to be seen whether the current crisis will follow a pattern similar to those of the past.”
 
Jefferies, a boutique brokerage and investment bank, also considers valuations as the key in an environment of volatility and uncertainty. In its equities research report titled, Darkest before the Dawn, the firm’s microstrategy research team explains that while the pandemic has no recent precedence, history can provide important insights.
 
It believes that global equities are now starting to price a deep recession, and excluding the US, PB (price-to-book) levels have now reached points last seen in 2008. “During periods of volatility, earnings-based valuations become unreliable while PB comes into focus. On PB, MSCI AC World ex-USA, is now trading only 6% from GFC (global financial crisis) lows. Should markets stabilize from here, our PB model suggests an upside of 25% with almost a 100% hit rate of positive return over the next 12 months.”
 
During the GFC, it also notes that the 2008 profit growth was down 35% as equities corrected by 50%. “With the MSCI AC World already down 27% since pre-Covid-19 peak, markets are now roughly pricing in a 20% profit drop this year. Hence, any further correction presents a significant opportunity for long-term investors.
With Covid-19 declared a pandemic, and with the Fed taking emergency action, the time to re-enter the market may be some months off. How markets perform in the weeks to come, however, will surely have an impact on the outcome of the US election in November 2020, and whether there will be a new beginning, including for those with spare cash to invest into the next upcycle. Watch this space. 
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