In last week’s blog, members of Invesco’s Global Market Strategy (GMS) team in Hong Kong, Italy, London, Tokyo and New York shared their on-the-ground insights of the fight against coronavirus from a health care, monetary, and fiscal perspective. Today, we take a deeper dive into the potential implications of the pandemic on U.S. stocks and bonds, as well as the GMS team’s view of asset allocation considerations.
Q. What technical indicators can help determine if the U.S. equity market is getting closer to a bottom?
Talley Léger (New York): In a challenging market environment like this, I believe investors should employ technical analysis, which can help inform timing decisions around major market turning points long before the economic data do. Indeed, the stock market must bottom before a new business cycle can begin. Here’s a comprehensive list of tactical indicators that offer an optimistic view that we may be near a market bottom:
- The Chicago Board Options Exchange (CBOE) Volatility Index (VIX). Extreme investor fear has typically coincided with major market lows. The VIX, which is commonly known as the “fear gauge,” has hit its highest percentage increase of the cycle and in its history, which is positive from a contrarian perspective. Since 2008, we’ve seen four equity volatility spikes above 70%.1 Encouragingly, the returns on the S&P 500 Index were positive for the 12-month period following each episode (excluding the current experience), with a median return of 8%.1
- The CBOE equity put/call ratio. This indicator measures seller positioning relative to buyer positioning. A ratio greater than 1 indicates more sellers than buyers and usually aligns with big market bottoms. The put/call ratio recently hit its highest level since 2008, when markets were in the depths of the Great Recession and Global Financial Crisis, which means that today’s pessimism is overwhelming.
- The percentage of New York Stock Exchange (NYSE) stocks above their 200-day moving average. This is a gauge of breadth, or lack thereof in this case. Today’s low percentage reflects weak breadth and an extremely oversold condition, which is constructive, in my view.
- The S&P 500’s deviation from its 200-day moving average. The stock market has fallen below its 200-day moving average to a degree not seen since 2008/2009, 2002, and 1974.
- The U.S. Economic Policy Uncertainty Index. This index – which is based on a daily news-based search for the words “economic policy uncertainty” – recently hit its highest level in history. However, I believe that the U.S. Congress’ coronavirus stimulus package should ease uncertainty from this record high and help stocks further along the bottoming process. To further reduce uncertainty and aid this process, the global fiscal response needs to become coordinated and forceful.
- The 1987 crash versus the 2020 coronavirus crash. This cycle-on-cycle comparison is lining up well so far, in my view. The S&P 500 Index fell over 30% from peak to trough in both crashes, followed by double-digit rebounds from the initial lows.2
On the other side of the coin, however, is a list of tactical indicators that are signaling the potential for further weakness in share prices ahead:
- The American Association of Individual Investors (AAII) Sentiment Survey. The percentage of bearish minus bullish respondents has gotten negative but hasn’t become cataclysmic yet. A bull-bear spread of -30% or less would suggest an approaching seller climax, but we’re not there yet.
- The slope of the U.S. Treasury yield curve. The yield curve – or the difference between 10-year and 2-year government bond yields – is a signal from the fixed income market that the economic outlook is either getting better or worse. The curve has steepened somewhat, which is good, but it has usually been much steeper near significant lows in stocks.
- The U.S. stock-to-bond ratio. This ratio – a measure of investor risk-off positioning – shows that stocks (weak) and bonds (strong) are behaving like the economy is already contracting. While much of the coming fundamental damage is getting priced in, this ratio hasn’t turned yet.
- The U.S. cyclical-to-defensive ratio. This indicator – a measure of investors’ defensive posture – shows that the economy-sensitive sectors of the market (consumer discretionary, energy, financials, industrials, information technology, and materials) have remained understandably out of favour.
- U.S. coronavirus cases. Virus-related uncertainty could continue to weigh on stocks until the number of cases peaks.
Putting it all together, near-term chaos can create long-term opportunities for patient investors. We’re starting to see the kind of despair that kills old bull markets and gives birth to new ones. To be clear, bottoming is a process, but indications of excessive caution in the marketplace suggest savvy investors should start looking for opportunities to be contrarian when others are fearful.
Q. What is the U.S. bond market telling us?
Tim Horsburgh (New York): U.S. fixed income assets staged a marked reversal last week by rallying after an almost unprecedented decline in prices during the first three weeks of March. The Federal Reserve’s forceful intervention on March 23 – with essentially open-ended quantitative easing and a raft of programs to help support various markets – has gone a long way to ease fears of a breakdown in market functioning. Similarly, while more targeted to end consumers to mitigate a demand shock, the fiscal stimulus signed by President Donald Trump on March 27 has also helped ease fears that the sudden stop in many economic activities would prove calamitous for even healthy and well-funded credits. Bid/ask spreads have tightened and, importantly, new deals are transactions are still getting completed.
We believe the recent dislocation has opened opportunities for investors seeking attractive entry points in fixed income. While an economic recession seems almost assured at this point, bonds won’t suffer equally. The Fed’s support will not be able to prevent genuinely distressed credits and companies from going bankrupt. We still favour looking higher in the quality spectrum for some of the best potential reward at this point in the cycle.
Even though spreads likely peaked last week for investment grade bonds, in our view, highly rated credit still looks attractive because it will likely be better able to withstand the coming wave of defaults and bankruptcies associated with even a moderate recession. High quality municipal bonds may also offer opportunities given still-high spreads over Treasuries. Municipal bonds have also historically defaulted at lower levels than many corporate bonds of similar quality. We expect mortgage-backed securities and structured credit to also do well as spreads tighten. The Fed’s decision to intervene in some form in all of these markets should also add an additional tailwind to performance.
High yield bonds, on the other hand, will likely prove more challenging for investors. With the asset class (represented by the Bloomberg Barclays High Yield Index) having an approximately 10% weight to energy3 andgenerally lower quality balance sheets, there will likely be more price declines and defaults in the future as the recession takes hold. Valuations in high yield are starting to look attractive from a historical standpoint, but with fundamentals deteriorating, it will take time before high yield defaults peak.
While dislocations are likely to persist for some time in the fixed income market, the worst is likely behind us in terms of liquidity fears now that the Fed has stepped in. We believe investors should consider adding to high quality fixed income to potentially take advantage of above-average spreads and solid fundamentals.
Q. What is an asset allocator to do? Any words of wisdom for short-term tactical moves?
Paul Jackson (London): We are living in a world of extreme uncertainty. Assessing the financial market implications of a partial or total economic shutdown in a range of important economies is virtually impossible. Given the unprecedented circumstances, the best we can do is construct a range of scenarios (for example, our 12-month targets for the S&P 500 range from 1,400 to 3,000).
We have witnessed extreme market volatility in recent weeks, and I can imagine three potential circuit breakers (against the panic): a working and approved vaccine; a clear reduction in COVID-19 cases and deaths outside of China; and policy support. Given that a vaccine is unlikely to be available for 12-18 months, in my opinion, and that non-Chinese cases and deaths continue to accelerate (with the U.S. now becoming the center of attention), it has been left to policymakers to calm the markets.
While governments unfurl ever larger fiscal packages to protect their economies, major central banks have announced massive asset purchase programs, which have the double effect of calming markets and effectively financing the surge in fiscal deficits. Our projections for the aggregate balance sheet of the major central banks (Federal Reserve, European Central Bank, Bank of England, Bank of Japan and Swiss National Bank) suggest that expansion in the period to end-2021 may be as rapid as has been seen in the last decade (in year-on-year percentage terms). It is also our observation that such growth has tended to be followed by improved performance in global assets (according to our own global multi-asset benchmark).
However, it seems that we are in unprecedented times, and it is difficult to yet quantify the economic damage wrought by attempts to control COVID-19. Our very worst-case scenario (from which the S&P 500 1,400 target arises) imagines that global gross domestic product (GDP) could shrink by 3.5% this year and that markets return to Global Financial Crisis conditions (in most cases, we remain far from that).
Consequently, and as I mentioned in my brief remarks in last week’s blog, diversification is more important than ever but is harder to achieve than usual, given that assets are moving together (correlations have risen). Among “defensive” assets, I believe cash and gold warrant the greatest consideration for investors. Government debt could also fulfil that defensive role now that major central banks have launched big purchase programs, but yields are historically low and government deficits could reach war-time proportions (in my opinion).
I believe a barbell approach of combining those “defensive” assets (cash and gold) with commodities and real estate (REITs) could offer potential benefits. They are the cyclical assets that I think have the most upside under our more optimistic scenarios.
Equities may also be an important part of any long-term investor’s portfolio. Equity markets that I believe have the most upside potential in the shorter term include the U.K. and Japan. However, on a global basis, I think there may currently be more efficient ways than equities to gain exposure to an economic recovery (for example, a combination of investment grade credit, REITs and commodities may potentially provide such exposure).
One asset class I would highlight in today’s environment is investment grade (IG) credit. In my view, IG would seem to offer a good combination of risk, reward, and diversification potential. I am, however, more wary of high yield credit, echoing Tim’s comments above.
Finally, some assets have been more impacted than others and have priced in a greater degree of bad news. In my opinion, this list includes oil (the price of West Texas Intermediate briefly touched my long-held downside target of $20 on March 30); sterling, which fell to around 1.15 on March 19 and close to historical lows versus the U.S. dollar; and REITs (the global yield was 5.3% and U.S. yield was 5.6% on March 26, based on FTSE/EPRA NAREIT indices).4 Given this view, UK oil stocks may warrant consideration, as they give access to oil assets in a depressed currency.
Talley Léger is a Senior Investment Strategist who specializes in the equity markets for the Invesco Global Market Strategy team.
Tim Horsburgh is an Investment Strategist who specializes in fixed income markets for the Invesco Global Market Strategy team.
Paul Jackson is the Global Head of Asset Allocation Research for the Invesco Global Market Strategy team.