Markets and the coronavirus: are we heading for a correction?

European stock markets are particularly vulnerable, writes Jason Hollands.

It’s been brutal week so far for stock markets – and we are, of course, only part-way through it - as fears about the spread of the COVID-19 virus across the globe have sparked panic. The S&P 500 index of leading US shares was down by circa 6.3% so far this week at Tuesday night’s close and the UK’s FTSE 100 is also off by more than 6%, dipping below the 7,000 support level. 

Such movements in the space of a couple of days has understandably raised talk of a whether we are heading for a full blown “correction” within days. As a reminder, the widely recognised definition of a correction is a decline of more than 10% (a “bear market” is a slide of 20% or more) and there have been around 15 of them on the S&P 500 over the past 70 years.  

Frankly, some markets have been looking vulnerable to a sell-off recently, with a number of indices having hit record highs and share valuations in the US trading well above longer-term trend. Normally, such dramatic slides in markets take place during recessions or macro-economic shocks and there is no doubt that COVID-19 is already counting as an extreme demand shock to the Chinese economy on a plethora of measures. Even where factories have re-opened in China, these are running at 40% to 50% capacity.  

Prior to this week, markets appeared to have been buoyed by data indicating a slowdown in new infection rates in China, as well as expectations of monetary stimulus by central banks (as we’ve already seen in China) and therefore factoring a short and sharp hit, followed by a V-shaped recovery - similar to that seen with the SARS outbreak in 2003. Although volatile, on the whole, stock markets had – until recent days – proved a lot more resilient than many might have expected in the face of crisis in China.

However, the clear spread of the virus into developed markets with a surge of reported cases in Italy, has raised the prospect of lockdowns and severe economic disruption in Europe and beyond. A global pandemic, with extreme economic disruption, is not good for stock markets anywhere. Period.

Sectors that are especially vulnerable to the shock impact of lockdowns and slower growth include airlines, tourism, manufacturers, oil and financials. In the case of the latter, this is because of the prospect of further cuts to interest rates as central banks inject additional liquidity into the financial system. Low rates squeeze the margins that can be earned on lending activity. The bond markets are now factoring in rate cuts globally. While shares have been sliding, bonds have rallied, with 10-year US Treasuries closing on Tuesday at their lowest yield ever – 1.352% - since records began in the 1790s.

European stock markets are particularly vulnerable at the moment. That’s partly owing to the rise in infection rates across Europe – with the cases reported in Austria, Croatia and Switzerland – and the ease at which the virus can spread across national borders within the EU, but also because the composition of European equity markets has a lot more exposure to cyclical sectors and export-orientated manufacturers than either the US or the UK.

Europe is heavily exposed to the slowdown both in China, and a hit to global trade, and the banking system in Europe has never fully recovered since the global financial crisis. Ominously, Europe is also poorly equipped to mitigate this crisis as bond yields and real interest rates were already negative in the eurozone prior to the crisis. The European Central Bank has very little left in its armoury to be able to respond by way of stimulus. The EU’s tough stance on a future trade agreement with the UK, risks exacerbating Europe’s currently vulnerability.

What should investors do?

When markets are on the slide, it is all too easy for private investors to get swept up in the panic and to start cashing up their long-term investments and in so doing turn paper losses, into real, crystallised ones.

These are times that require nerves of steel and investors should remind themselves of their real investment time horizon, as to when they expect to utilise their investments. In many cases, this may be decades away, in order to finance their retirement, and therefore reacting to a week on the markets carries its own risks. Just as sharp slides can happen in remarkably short time periods, so can relief rallies. Trying to accurately call the bottom of a market retrenchment correction is nigh impossible.  

What we do know, is that sharp slides in markets ultimately reward long-term investors who are prepared to go against the herd and invest new money at lower stock prices than they may have paid just weeks earlier. This does not mean that investors should throw caution to the wind and aggressively pile in, as markets may worsen before improving (who knows?), but there is a case for steadily feeding new cash into the market over the coming weeks and months, which should have the effect of smoothing out the price at which shares are purchased at. 

UK equities continue to offer relatively better value than other developed markets and provide the support of attractive dividend yields. My top picks for UK equity funds include Liontrust Special Situations and TB Evenlode Income, both of which have strategies that avoid exposure to sectors and businesses that are highly sensitive to the economic cycle.

In the case of the Liontrust Special Situations fund, this has historically proven a particularly resilient performer in tougher market conditions, a vindication of a focus on companies with resilient earnings and high barriers to competition.  

Jason Hollands is managing director of business development and communications at Tilney Investment Management Services Ltd.

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