Coping with Coronavirus-Induced Market Volatility: A Multi-Asset Update

Edward D. Perks, CFA

Edward D. Perks, CFAChief Investment Officer,Franklin Templeton Multi-Asset Solutions

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Gene Podkaminer, CFA Head of Multi-Asset Research Strategies,Franklin Templeton Multi-Asset Solutions

The spread of the coronavirus has created heightened market volatility in recent weeks, but the Franklin Templeton Multi-Asset Solutions team remains focused on long-term market fundamentals. Here, Ed Perks and Gene Podkaminer offer an update on how they are approaching the situation, and which countries appear more insulated to growth shocks.

We begin by re-emphasizing the key conclusion of our last commentary on this subject: we believe it is important to maintain diversified portfolios, particularly in times of increasing investment uncertainty. This approach has proven to be beneficial over the last several weeks as volatility has picked up in equity, fixed income, and commodity markets.1

We continue to follow a process that resists the temptation to trade around news flow and emotion. Instead, we focus on how the evolving macro-economic backdrop is affecting market fundamentals and adjust our asset allocation views accordingly. Our asset allocation strategy focuses on regions that are more insulated from the growth shock and have enough policy flexibility to respond accordingly. The United States and the United Kingdom both fit this description, whereas the eurozone is in a less favorable position.

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More broadly, the range of uncertainties—both medical and market—tempers our enthusiasm to increase holdings of stocks and other riskier investments at this time. However, as we look ahead over the next year, we continue to see attractive return potential from global equities.

Reviewing Our Initial Premise

Our initial premise was that the coronavirus would impact economic growth with the following characteristics:

  1. Geographic: Centered around China and Asia
  2. Duration: A sudden short shock that would be mostly felt in the first quarter of 2020
  3. Response: The greater the growth impact, the larger the commensurate policy response

We are closely monitoring the situation to validate if these views are supported by updated data. Given recent developments, below are some of our updated views.

Update: Geographic Impact

There is little doubt that Chinese economic activity has slowed during the first quarter of 2020; it is more a question of by how much? A variety of daily production indicators, such as passenger traffic or daily power coal consumption, signal very little rebound in activity. Business confidence surveys reflecting February activity also confirm the growth slowdown in China.

Exhibit 1: China: Business Confidence Surveys August 2014–January 2020

Sources: Franklin Templeton Capital Markets Insights Group, Bloomberg, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com.

Outside of China, we can observe that the slowdown in activity is having an impact on neighboring countries in Exhibit 2 below (most recent datapoint reflects February activity).

Exhibit 2: Coronavirus Impact: Japan Composite PMI and South Korean Consumer Confidence May 2017–February 2020

Sources: Franklin Templeton Capital Markets Insights Group, Bloomberg, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com. The Japan Composite Purchasing Managers Index (PMI) is an indicator of economic health in manufacturing and services. A reading below 50 indicates contraction, while above 50, expansion.

While it makes sense that Asia is most impacted, there are other sectors that should be insulated from an Asian growth shock, in our opinion, such as the developed market consumer and labor markets. We track recent sentiment surveys to understand how consumer confidence is evolving amidst the changing global macro backdrop. As of February 25, we see limited impact to developed market consumer confidence outside of Asia (Exhibit 3).

Exhibit 3: US and Eurozone Consumer Metrics (Z Scores) January 2018–February 2020

Sources: Franklin Templeton Capital Markets Insights Group, Bloomberg, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com. The University of Michigan (UofM) Index of Consumer Expectations represents focuses on three areas: how consumers view prospects for their own financial situation, how they view prospects for the general economy over the near term, and their view of prospects for the economy over the long term. The US Conference Board’s Consumer Sentiment Survey’s Expectations Index is based on consumers’ short-term outlook for income, business and labor market conditions.

We can also track broader indicators of the US and eurozone service sector. Here, we observe additional evidence of mixed data as the US Markit Purchasing Managers Index (PMI) fell sharply, whereas the eurozone service PMI rose month-over-month (both reflecting February activity).2 See Exhibit 4.

Exhibit 4: Markit Service PMIs: US and Eurozone March 2017–February 2020

Sources: Franklin Templeton Capital Markets Insights Group, Bloomberg, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com. The Purchasing Managers’ Index (PMI) surveys measure the activity level of purchasing managers in the manufacturing or services sectors. A reading above 50 indicates expansion in the sector, while a reading below 50 represents contraction.

While following data flow on a month-over-month basis may be noisy and often unrewarding, the recent divergence between these two economies, led by the US service sector, has caught our attention. The US consumer and service sector would be vulnerable if the virus spreads more widely in the United States. We would expect more resilience in these two sectors unless, or until, this occurs, and we will continue to monitor closely.

Update: Duration Impact

Our initial view on the coronavirus was that the duration of impact would be short-lived as Chinese policymakers were going to great lengths to contain the virus in Hubei. Since then, the number of reported cases in China has slowed, but the coronavirus has spread to many countries across the globe. Clusters of the virus have sprouted up in South Korea, Italy and Iran. As of February 26, the World Health Organization had reported more new cases outside of China (459) versus inside of China (412).3 The number of countries affected has grown to 37.4

The virus is difficult to contain, as symptoms can be mild and similar to the normal seasonal flu. While there is still a possibility that China sees continued deceleration in cases, this remains an open question as many workers are returning after an extended break and are starting to resume normal activity, which will render containment more difficult. Globally, it seems likely that more clusters will emerge. This ultimately means the duration of the impact will likely be longer than previously envisioned.

Update: Response Impact

Our expectation has always been that this growth impact would be met with a proportional policy response. So far, we have seen many policy responses across the globe and our initial assessment has held up thus far. These are some of the notable responses (as of February 26, 2020):

  • Hong Kong announced stimulus equivalent to approximately 4.3% of current nominal gross domestic product (GDP).5
  • Chinese CY2020 local government bond issuance quota now amounts to US$268bn (1.7% of GDP); much of this is front-loaded.6
  • The People’s Bank of China cut interest rates on its 7-day and 14-day reverse repurchase agreements by 0.10%.
  • On February 9, China’s Ministry of Finance announced that RMB72 billion (US$10.26 billion) has been earmarked to support the most devastated areas.

Moving forward, falling oil prices and the low inflation backdrop should allow global central banks to maintain or extend stimulative monetary policy. We are already seeing this being priced into market expectations for official interest rates.

Exhibit 5: Fed Dot Plot vs Futures Curve Dot Plot as of January 2020 MeetingOIS as of February 26, 2020

Sources: Franklin Templeton Capital Markets Insights Group, Bloomberg, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com. OIS (overnight index swap)/market consensus. Participants’ projections of the appropriate level of the target federal funds rate (rounded to the nearest 1/8 percentage point) at the end of the specified calendar year. Participants’ projection are summarized in the form of a median, weighted average, central tendency and range. The central tendency is the range of participants projections, excluding the three highest and three lowest projections for each year.

Fed funds futures are a widely used tool for hedging interest risk and are a reflection of collective market insight regrading the future course of Federal Reserve monetary policy. There is no assurance that any projection, estimate or forecast will be realized.

Lastly, we also want to consider how policymakers will respond to the virus itself. The typical response by policymakers has been to quarantine symptomatic individuals in order to prevent further transmission of the virus. Additional measures, such as travel restrictions, are also being imposed, to various degrees. These measures are helpful in containing and preventing the spread of the virus but come with an economic and social cost.

It is interesting to recall that during the early days of the H1N1 influenza outbreak in Mexico, policymakers initially engaged in quarantines, restricted travel, and more. Eventually, these policies were abandoned due to the economic and social cost. H1N1 is an intriguing case study as the mortality rate turned out to be quite low. We have yet to see if coronavirus mortality rates eventually fall to a level similar to that of H1N1.

Asset Allocation Takeaways

As we update our initial assessment of the coronavirus, a few things have changed. While the growth impact has thus far been centered around China and Asia, the spread of the virus is making it more likely that the growth impact extends to the rest of the world. It will be difficult for the US consumer to remain resilient if the virus becomes more widespread in the United States. The policy responses thus far have been encouraging.

From an asset allocation perspective, we continue to prefer regions that have the policy flexibility to respond to a growth shock, such as the United States and the United Kingdom. Areas like the eurozone, with constrained monetary policy and fiscal challenges, will face a tougher road ahead if the virus spreads further through the region. From a broader portfolio perspective, we continue to believe that navigating the challenges the year ahead presents will require nimble management.

ENDNOTES

  1. Diversification does not guarantee profit or protect against risk of loss.

  2. The Purchasing Managers’ Index (PMI) surveys measure the activity level of purchasing managers in the manufacturing or services sectors. A reading above 50 indicates expansion in the sector, while a reading below 50 represents contraction.

  3. Source: World Health Organization, as of February 26, 2020.

  4. Ibid.

  5. Source: ISI.

  6. Source: Morgan Stanley Research, as of February 12, 2020.