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Who knew where Wuhan was?

22nd April, 2020

When people hear the phrase 'may you live in interesting times', most believe that the words come with good wishes from the speaker. But the origins, an ancient Chinese curse, are of a more malevolent nature and given what we have seen in markets over the last few weeks, I am rapidly coming to the conclusion that 'interesting times' are very overrated!

The first three months of 2020 have been a lesson in how far and how quick investor sentiment can swing. For much of January and February there was little that could dent the enthusiasm of markets - not even the increased geopolitical tensions between the US and Iran, nor the initial news of the coronavirus in China. All the while the positive sentiment was fuelled by the accommodative stance of central banks as they pumped liquidity into the global financial system.

As the news first broke, many people may have believed that the emergence of the coronavirus in a region of China was likely to be an issue that would be contained there. But as time passed and the virus spread through Asia, markets began to sit up and watch. It wasn't until it landed on European, and in particular Italian shores that the party came to a shuddering halt.

Since then we have seen a dramatic and volatile lurch lower with many major equity markets surpassing the traditional bear market level of a 20% decline. The situation has not been helped by a significant fall in the oil price as disagreements between Russia and Saudi Arabia have created an imbalance in the supply/demand equation for oil.

As investors try to assess the likely economic and, more importantly, corporate profit impact of the coronavirus, it is worth posing the question of what has already been priced into markets given the selloff. To this end, the tables below try to back out the profit change in 2020 over 2019 implied by various index levels for the S&P 500 and the EuroStoxx for a given valuation.

 Table 1: S&P 500

Source: Davy; Currency USD; data retrieved from Bloomberg as at 20th March 2020

Table 2: EuroStoxx

Source: Davy; Currency EUR; data retrieved from Bloomberg as at 20th March 2020

To explain this, if we look at table 1, the S&P 500, over the long term the average price/earnings (PE) ratio has been in the range 17-18 times, therefore with the index at 2400, we can see the market is already implying that profits will fall between 14%-19% in 2020.

At this stage it is impossible to definitively say that the virus will cause a global recession or what the degree of any recession would be, but with markets already pricing in double digit contractions in profits, the question becomes how much worse could it be from here?

During the global financial crisis, US corporate profits fell 40% in the first year of recession – to put that in context it was nearly twice the size of previous recessionary profit contractions - only to rebound for the next 10 years after that. But the consumer and corporate landscape are more favourable now.

Household and company balance sheets are stronger now with lower levels of debt and debt servicing permanent - a marked contrast to 2008.

While consumer activity will reduce near term, this will be driven by an inability to spend, rather than a desire not to spend. And with mortgage rates and petrol prices falling, consumers will find their disposable incomes increasing - at a time when they can't spend it! The last decade has seen company profit margins improve as managements have focused on productivity and efficiency improvements to their business models. This will allow them to better weather the storm with improved cash flow generation during any slowdown.

One factor that has not changed from the last recession is the commitment of monetary authorities and governments to 'do what it takes' to protect the global economy and financial system. We have seen significant fiscal packages announced that will inject cash into businesses to keep employees on the payroll, provide credit to companies to meet short term cash flow requirements, or the biggest and potentially quickest form of stimulus would come from sending money directly to people - the so called 'helicopter money' programme.

It is still too early to accurately predict the full impact of the coronavirus on the global economy and its consequences for corporate profit, but with so much priced in already, what is the probability that it is worse than that?

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This article is from our April 2020 edition of MarketWatch.

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This article is from our April 2020 edition of MarketWatch.

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