Closing in on the bottom

In the past few days, a series of new developments seem to indicate that the market may have found a bottom, at least temporarily. We believe that a floor may be found based on a combination of i) attractive-enough valuations; and ii) improved clarity on the possible timeline for an end to the coronavirus crisis, likely in the form of improving Italian infection data.

On valuations, we highlighted 2,200 on the S&P 500 as a level that would be commensurate with previous bear markets and recessionary pullbacks. On 24 March, the index rebounded twice on that level, as news of a $2tn US fiscal Covid-19 response package emerged, which corresponds to a 35% compression in trailing valuations. While this is by no means an absolute floor, it is encouraging to see buyers stepping in at the “right” valuations.

Italy’s worst-case Covid-19 scenario

On the Covid-19 pandemic, we think that part of the extreme volatility seen in markets was linked to the exceptional difficulty, of not impossibility, of forecasting what comes next. In this context, Italy was seen as the first good template for what may lie ahead in other parts of the world. Indeed, unlike China where only a small part of the country was in lockdown or South Korea’s far superior testing capabilities, Italy, unfortunately, offers a glimpse of a worst-case scenario could look like.

After weeks of almost total economic and social shutdown, Italy has final seen daily deaths linked to the coronavirus start to decline. From a peak of 793 deaths reported on 21 March, the average over the last three days has been around 665, showing some tentative stabilisation. Again, a relapse is possible and we could see cases jump again, but we view the recent trend positively.

Extrapolating Italy’s experience to the rest of the developed world would suggest that the peak of the health crisis could occur in late April. Of course, this assumes that other countries implement similar measures to Italy’s lockdown.

Not out of the woods yet

We may not be out of the woods just yet. Indeed, a lot of questions remain. On the Covid-19 outbreak, the risks around a second wave are not clear. While infection rates would likely be less severe as more people have developed immunity, a second round of lockdowns would be as damaging to global economies.

On the economic front, we are just starting to get an idea of those damages. Purchasing managers’ indices registered their biggest month-on-month drop on record in March and jobless claims are soaring. Default rates are also likely to increase. Everybody expects a sharp, and unprecedented, slowdown in activity. However, the timing, the pace and the magnitude of the rebound remains highly uncertain at this stage.

Focusing on quality is paramount

We expect continued volatility in the medium term and can’t rule out further sell-offs. As such, from an investment perspective, we believe that long-term investors should avoid a passive approach. While value and “beaten down” sectors or companies will likely outperform in a recovery scenario, we remain convinced that focusing on quality and appropriate diversification is paramount.

For those looking for distressed situations, we believe that the most attractive opportunities will arise in private markets where managers can help influence companies’ fate (as opposed to just relying on government support in listed market).

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