On the 11th February there were two very different headlines on the coronavirus:
This was indicative of confusion that many felt at the time. Though he later qualified his statement, Dalio seemed to be reflecting a complacency in markets that was at odds with the views of the experts.
In fact, far from being exaggerated, market moves actually appeared to have been muted relative to the news flow. At the time that the above articles were published there had been some sharp moves in China and commodity-related stocks, but Western developed markets had been resilient.
In fact, as recently as last week, the US market had reached all-time highs.
Many, particularly those who already saw the US equity markets as displaying bubble-like behaviour, saw this as a further sign of the “suspension of reality” going on in global markets. Those who believe that bond markets are ‘more intelligent’ than their equity counterparts saw the fact that Treasury yields were falling at the same time as an indication that bond investors ‘were on to something’ that excitable stock investors had missed (ignoring the argument that it may have been the lower rates themselves that were supporting equity valuations).
On Monday, this all changed. Seemingly triggered by the announcement of further cases of infection and strict restrictions of movement in Italy, market moves in Western markets were relatively sharp:
And equity markets and bond yields once again fell together:
Why had markets previously been so apparently complacent, and were the sudden moves really about Italian news, or could there be something else going on? And what might an assessment of the price/news relationship tell us about possible opportunities today?
Slow to overreact?: Markets reacting to news, and news reacting to markets
On the surface, we can simply interpret price moves as reacting to the new information we have received. Original virus cases were centred in China, with some spread elsewhere in Asia, and so market moves were strongest there. Subsequently, we saw actions in Italy, and so developed markets reacted accordingly.
And yet for many of us, the natural feeling is that markets are being hopelessly naïve: we already had the warnings from the WHO (amongst others), there were already cases reported in Italy and elsewhere (a useful timeline on the outbreak can be found here). Is it really a surprise to see things develop as they have? Recent headlines certainly seem to reflect the hindsight bias that many of us feel:
It can often be the case that markets appear to ignore apparently significant developments. In 2017, we suggested several reasons why this might be, particularly in cases where outcomes can be extreme and non-linear. The question is, are markets being complacent today? After all, as figure four shows, market moves so far have still not been huge in the context of the last couple of months and, in cases like this, even the potential for a worst case scenario is a powerful argument for the ‘precautionary principle.’
On the flipside, our experience of markets suggests that in phases like this week: when asset moves are rapid, when clients nervously begin to ask about our views and positioning, and when the issue of the day dominates headlines above all others, it is often a sign that panic is taking hold.
Rather than responding to new information, price moves can themselves begin to drive the ‘news’, shaping investor perceptions and driving prices further:
Dealing with apparently complacent markets is challenging, the reality is that there are always potential risks to returns, and even when such a risk becomes more salient experience suggests that we should be very wary of thinking that we know more about the market as to how bad things can and will get.
However, in latter case of panic, ‘feedback loops’ between price and news can be a source of opportunity for ‘episodic’ investors. Importantly looking for such opportunities involves being reactive, not seeking to have an information-edge in epidemiology.
Looking for opportunities
As well as assessing sentiment and market commentary, identifying episodic opportunities involves assessing the signals provided by price action and valuation.
First, as noted above, despite feeling uncomfortable and gaining headlines, price moves have not been significant as yet; in many cases equity markets have simply returned to their levels of a couple of months ago, albeit with potential pockets of opportunity opening up in specific regions such as Thailand or at a stock and sector level.
Moreover, large episodes are usually characterised by correlation across assets: you may find investors following the ‘risk off playbook’: seeking liquidity at all costs, and ignoring previously held long-term views in favour of near term ‘safety.’ There are signs of this at present (gold might be one example) but in general the market has been more discerning than typically seen in full-blown episodes. After the West had shown resilience initially, Asia has done so more recently.
The other key element is valuation. Real panic is often associated with very attractive valuations. However, although we have seen some de-rating across equity markets this is in many cases coming from a position of valuations that were already quite rich (as Tristan noted last month).
The collapse in bond yields is potentially more interesting. US long-dated Treasuries yields are now lower than amidst last summer’s recession fears and QE excitement: is this a genuine change in perspective on the thirty year outlook for interest rates and inflation, or just a safety play? At the same time, Gilts and Bunds have not fallen below those summer levels: does this suggest that their potential to offer protection against equity positions may be more limited?
Finally, opportunities can arise when panic impacts areas that are not directly exposed to the risk that is worrying markets. To offer two examples, Italian bonds have sold off while others have rallied sharply: is this a reflection of the solvency of the Italian government, or simply an aversion to any Italian asset? Similarly, US tech stocks, which last year had recently been seen as both relatively immune to global slowdown fear, and beneficiaries of lower rates (as ‘long duration’ equities), have sold off along with everything else.
In both these cases however, as with equity markets in general, the recent sell-off comes after a period of very strong performance and less compelling valuation that have existed in the last couple of years.
Recent price moves bear some of the hallmarks of a ‘classic episode,’ most notably in the way that there seems to have been a shift from markets taking their lead from genuine new information, to price moves themselves beginning to influence investors’ beliefs. However it remains the case that the extent of this episodic behaviour is still relatively modest (consider the pessimism that dominated at the end of 2018) and that valuations have not moved materially in many cases relative to their levels in recent years.
Just as important is to consider that in cases such as this, when worst case scenarios can be very extreme (e.g. exponential spread of a virus) and risk characteristics are somewhat binary (e.g. whether a government decides to shut down freedom of movement or not), scaling of exposures is important. The extent to which prices can move against you may be greater, and so being in a position to add more exposure as they do so may involve smaller capital allocations.
The real world impacts of the coronavirus are tragic and profound, and today’s investment mood has changed dramatically from the relative comfort of only a month ago. Ultimately however, the greatest opportunities occur when investors (including ourselves) are at our most fearful, and in that respect this is an episode that is still developing.