Coronavirus outbreak: now for the reckoning

The acceleration in the number of coronavirus infections outside of China has sent a shockwave through the financial markets and encouraged radical reductions in economists’ global growth forecasts.

Economic outlook

Future growth prospects will be determined by the lifespan, intensity and geographical spread of the virus. We forecast a significant reduction in economic activity for the first half of this year.

The most aggressive downgrades for growth have focused on China, Japan, South Korea and Europe. We expect the Chinese economy to contract by 8% in the first three months of the year and for Europe to enter a technical recession in the first half of 2020 (H1). For the full year, we now forecast growth of just 1.8% (many economists consider a rate below 2% to be a global recession).

Magnitude of the disruption

The magnitude of the economic impact will be determined by the disruption to supply chains and the reduction in demand. Certain sectors are more vulnerable than others to the initial shock caused by the Covid-19 pandemic, including travel, retail and events. On the industrial side, manufacturing has been under pressure but is likely to recover more quickly.

Policymakers have reacted aggressively to support economies and stabilise markets. Central banks have slashed interest rates to historically low levels, restarted quantitative easing programmes and begun injecting massive amounts of liquidity into the system. While the measures will be supportive in the long term, they do not solve the underlying medical issues and resulting disruption.

Inevitably the outlook for global growth will remain tilted to the downside until the peak of the virus can be determined. However, the expectations are that this could be in a few months and so we could see early signs of a recovery in H2 2020. On this assumption, the outlook for 2021 looks considerably brighter and we currently predict that the global economy will bounce back with growth of 3.7%.

Equities

Although monetary and fiscal stimuli commitments have started to pour in, in response to the coronavirus pandemic, equities may need much stronger support for valuations before they can find their footing. Historically, a 35% compression in valuations (trailing price to earnings ratio) is necessary before a bear market starts turning.

We are already roughly two-thirds of the way there. However, because the correction happened so quickly, capitulation hasn’t had time to set in yet. This leaves us exposed to more downside and a U-shaped recovery as opposed to the V-shaped ones that have been seen in this cycle.

Yet, as soon as the pandemic appears under control, which according to scientists could be within the next six to ten weeks, we would expect an equally violent rebound. The rebound is likely to be led by beaten-down cyclicals, like energy or materials, and value-oriented sectors, such as financials and energy (as often the case in a “recovery scenario”). Until then though, we believe it’s prudent to stick to our long-lasting preference for higher quality and cash-generative businesses while using the elevated volatility to improve the risk/reward of any investment.

Fixed income

Sovereign rates are now depressed in all major fixed income markets. Meanwhile, US high yield spreads have widened by approximately 500 basis points (bp), since the end of February, to over 840bp and bringing the average yield to over 9.3%.

At current depressed oil price levels, much of the energy sector in the US high yield complex is at elevated risk of default, mirroring the situation during the energy crisis in 2016 when spreads were at similar levels.

This time weaker credit from the airlines, travel & leisure and retail sectors faces its own challenges which adds another layer of spread volatility. High yield bonds are trading well above their average but selection will be key. Emerging market bonds are overwhelmingly linked to commodity prices and spread widening has led to average yields over 6.5% in US dollars; the higher end of the range in the last 10 years. Meanwhile fallen angel risk, or risk of being downgraded to high yield status, has increased in the investment grade market.

That said, larger companies, in particular, seem to have sufficient levers to defend their rating while default rates should be relatively contained.

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