- The spread of coronavirus infections is having an impact on China’s GDP and on market sentiment worldwide.
- The recent drop in the markets comes after a powerful six-month rally that had lifted equity valuations.
- We believe the market may continue to experience heightened volatility.
As the number of new coronavirus infections worldwide grows, a significant global health challenge has emerged. As the disease takes a human toll, the contagion has understandably unnerved investors across global markets. The impact on investor sentiment has escalated in recent days. In the United States, for example, the S&P 500 Index has retreated since reaching an all-time high on February 19, 2020. Risk assets have corrected, equity volatility has spiked, and bond yields have plunged.
The investment context
Putnam's active investment managers believe that fundamentals drive the performance of financial markets in the long run, while recognizing that investor sentiment can move markets in the short term. We also keep a disciplined focus on real impact to the economy and businesses, with awareness that headlines can change sentiment.
Monitoring the effects on economic activity
While we are already seeing the economic impact of the coronavirus, we note that the situation is fluid and authorities are often revising data. An example of real impact is that many Chinese businesses have shut down, and this is impeding the supply of critical components for a range of industries around the world. The shutdowns are also leading to revenue loss for businesses that sell to China. In the United States, a handful of multinational firms have begun to issue warnings about revenues and earnings.
We believe the market may view sales and production disruptions caused by business shutdowns as temporary for the next few quarters. Businesses may benefit from the fact that investors expect their sales and earnings to be challenged. Therefore, we could see fewer surprise earnings misses.
Are we overlooking a greater concern for equity markets?
As we entered 2020, we noted the importance of earnings growth as a catalyst to drive stock prices higher after a strong 2019. In fact, we listed this as one of the main risks to returns for the year ahead because 2019 brought multiple expansion but almost no earnings growth.
The stock market today is not cheap. By mid-February, the S&P 500 price/earnings multiple had reached a high of 19.19 times 2020 earnings. This is rich relative to the average of 16.4x forward earnings for the past 25 years. In our view, the real concern should be high equity valuations combined with uncertainty around the dependability of earnings growth data.
Although the S&P 500 price/earnings multiple has contracted in the sell-off, it is still elevated relative to history. More downside is possible and likely. It is important to remember that the S&P 500 has rallied 20.66% from its low on August 2, 2019.
For markets, the real concern should be high equity valuations combined with uncertainty around the dependability of earnings growth data.
Outlook varies by region
The coronavirus is a serious challenge, and its impact will vary across global markets. For China, we expect that it will reduce GDP in Q1 2020 and possibly Q2 2020. As Putnam’s Michael Atkin wrote recently, we expect this to be a temporary hit to China’s GDP levels.
Export-centric economies will also feel the effects, chiefly Europe and other emerging-market economies. There may be some impact to U.S. GDP, although we believe it will be limited to specific companies. Consumers drive the U.S. economy, and the backdrop of low interest rates, low inflation, full employment, rising wages, and strong home prices is likely to keep consumer confidence intact. As a result, among global markets, we favor U.S. risk assets.
Investors should expect volatility to remain elevated. The recent strong rally left the market vulnerable to a reversal. It could escalate given the uncertainty about both earnings and the spread of the virus. We could see widespread second- and third-order effects on companies and supply chains, which could last several quarters.