By Lauren Goodwin, CFA; Multi-Asset Solutions Team for New York Life Investments Blog
Economic growth is slowing, and geopolitical risks abound. But the market has taken it in stride, backed by strong investor sentiment and favorable liquidity conditions.
That is, until the Wuhan coronavirus threatened to put a damper on the important Lunar New Year holiday in China.
How have markets reacted?
Threats of a coronavirus spread prompted “risk-off” behavior across asset classes, meaning that investors purchased U.S. sovereign bonds at the expense of equity markets. The S&P 500 Index lost 3% before recovering slightly, and the yield curve flattened.
In addition, market pricing has begun to reflect a change in expectations for the Federal Reserve (Fed)’s next move. Before last week, the futures market expected the next interest rate cut by the end of 2020. Now that’s priced to happen in October.
Why are markets reacting to this risk and not others?
The Wuhan coronavirus is a new, potentially significant, headwind to China’s economy. It is also very difficult to forecast. As such, it creates a downside risk to what was previously an optimistically-priced market.
Still, it’s not the first risk that we’ve seen play out this year. The Iranian situation and impeachment proceedings, by contrast, faded quickly from market attention. Why, then, has coronavirus struck a nerve with investors?
For one, fear plays a meaningful role in the market’s reaction to un-anticipatable events. There is a lot to research and evaluate that does not fall into normal models or investment processes; the knee-jerk reaction is to be concerned. In the case of the coronavirus, markets had more fuel for the fire: over the past two years, the links between China’s economic health and global production and trade have become well documented.
It is not clear what the ultimate outcome of the coronavirus will be. However, the message for investors is clear: there is a meaningful vulnerability in the markets.
What should investors do?
Risks are always present in portfolio management. We encourage investors to focus efforts on risks that will impact portfolios in the next 6-12 months. Risks with shorter-term or un-trackable impacts are unlikely to be worth chasing for most investors.
That said, we see risks for the next several years as skewed to the downside. With factors such as geopolitics, climate change, and populism, it also becomes more difficult to attach probabilities to possible outcomes.
The Wuhan coronavirus provides a helpful reminder that the combination of slowing fundamentals and elevated valuations makes market outcomes more vulnerable to shocks. For many investors, taking a more defensive portfolio posture could be appropriate. What are the priority risks for 2020?
There are a few key scenarios that would cause us to reconsider our portfolio positioning.
- U.S. 2020 election: It is important for investors to remember that politics do not have a sustained impact on markets—it’s policy that drives change. A volatile political environment in 2020 is nearly certain, and the results of the election could drive major sector changes (health care, pharmaceuticals, etc.). Until those results are clearer, politics are likely to be more noise than portfolio signal.
- Illiquidity issues: Falling global yields have prompted an increase in demand for higher-yielding private (or otherwise illiquid) market assets. This strategy can be effective when it meets investors’ risk tolerance and risk appetite. However, the proliferation of liquid instruments providing daily prices for illiquid securities (e.g., high-yield bonds, bank loans, etc.) should be treated with abundant caution. A scare in those markets could require non-strategic sales of public assets to meet redemptions. This raises the risk that changes in market sentiment and risk posturing could be difficult to accommodate without significant market disruption.
- Financial stability risk: Low interest rates and the accompanying search for yield can lead to excessive valuations, particularly in credit. We are not yet to pre-crisis levels, but it makes sense to watch closely for potential correction.
- Currency war: U.S. officials have at various times accused China, Germany, Russia, Switzerland, and Japan of gaining an advantage by acting to keep their currencies undervalued. We see a sustained, outright currency war as unlikely. However, the implications of a currency war would be widespread. Risk-off sentiment in financial markets would expand beyond currencies and into impacted country equity indices. Multinational businesses would suffer, as currency translation impacts make product placement and profitable sales more challenging.
Geopolitical risk and portfolio resiliency
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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