- Several of the factors that led equities to plummet at a record pace in February and March remain key risks to their recent upswing, Seema Shah, chief strategist at Principal Global Investors, said in a recent note.
- The coronavirus revealed unprecedented risk velocity, a term for the pace at which economic and market risks affect prices.
- While some of the lingering risk-velocity factors may now strengthen risk assets' upswing, others still present threats to investors.
- Here are the six factors highlighted by Shah, and whether she views them as a new market boon or critical hazard.
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Risk assets have nearly erased their coronavirus-induced losses, but several factors that accelerated their downfall remain.
The plunge from peak prices to bear market territory happened at record speed. The decline exhibited unprecedented risk velocity, or a heightened pace at which economic threats affect market valuations, Seema Shah, chief strategist at Principal Global Investors, said. But just as increased risk velocity drove prices lower at the start of the pandemic, the trend could drive a swift market recovery.
"Unlike the global financial crisis, or previous bear markets, the current crisis wasn't triggered by an unwinding of imbalances, central bank tightening, or high oil prices," Shah wrote in a note to clients. "This is an event-driven shock, and recovery should be less drawn out."
Markets' current levels reflect similar expectations for corporate profit growth. Several experts claim the rally is unsustainable, pointing to newly escalated US-China trade tensions and lofty unemployment figures as cause for concern. To determine whether such fears are warranted, Shah reflected on the risk-velocity factors she laid out at the start of the pandemic for clues on future market moves.
Here are the six risk-velocity factors that exacerbated the coronavirus sell-off, and how she expects them to either benefit or endanger risk assets' run-up.
The market-economy relationship
Recovery role: Market obstacle
Lofty stock valuations may have contributed to the markets' sharp selling in March, but after just a few months, equities are back to highly expensive levels. The S&P 500's forward price-earnings ratio sat at 23.75 as of Friday afternoon, its highest level since early 2000.
Such a rapid rebound, coupled with ballooning valuations, leaves markets particularly sensitive to a drop in investor optimism. A range of events can trigger a wild run back to safe havens, Shah warned, particularly a repeat of what caused markets to plummet in the first place.
"Markets are once again vulnerable to a negative swing in sentiment — certainly a second wave of infection that results in renewed lockdowns could bring this new bull market to an abrupt end," she said.
The 'fallen angels'
Recovery role: Obstacle-turned-booster
In the early days of the pandemic, Shah flagged that a widespread plunge in corporate credit quality could starve companies of fundraising methods. Once-investment-grade firms would slide into junk status, becoming so-called "fallen angels" unable to shore up cash for riding out a prolonged downturn.
The Federal Reserve shared her concerns. By making an unprecedented move into buying corporate credit, the central bank immediately backstopped credit health. The Fed later expanded its debt-purchasing to include companies that suffered a fall into the high-yield status, further reinforcing its support for firms' ability to raise emergency capital.
These central bank actions also spurred a "follow-the-Fed" attitude among investors. Billions of dollars rushed back into credit markets to take advantage of the policy backstop, allowing firms to issue debt before the Fed's relief program even began operations. Credit-health worries faded and a strong risk-on attitude among investors gave firms the support needed to stay afloat, Shah said.
Social media's role
Recovery role: Market obstacle
The past decade's rise of social media platforms formed "a global echo chamber to major, anxiety-inducing events," Shah said. This trend accelerated the spread of coronavirus fears around the world and, accordingly, "exacerbated a collapse in both investor and household confidence," she added.
Unfortunately for bullish investors, the opposite is unlikely to take place. Investors and the general public alike will run into a great deal of misinformation as the virus threat abates and economies reopen, making the proliferation of social media a strong headwind against a broad market recovery.
The rise of ETFs
Recovery role: Obstacle-turned-booster
Market experts feared the soaring popularity of exchange-traded funds and other systematic investment funds would fuel unhealthy concentration and intensify the next downturn. Their concerns were proven sooner than expected, as the coronavirus drove indiscriminate selling across nearly all risk assets. Stocks dumped by individual investors slid further as those with ETF exposure experienced dire aftershocks.
Yet Shah said she believes this prior negative factor can aid in sustaining markets' upswing. Investors have largely reached their limit of de-risking, she said, decreasing the likelihood of ETFs and similar instruments leading a market decline.
"If anything, as volatility declines further (aided by Fed measures), risk parity funds will likely start adding to the exposure, potentially driving equities higher," she wrote.
Globally stretched supply chains
Recovery role: Obstacle
Companies particularly exposed to China and its manufacturing sector bore outsized damage in the early days of the coronavirus outbreak. The fallout eventually spread around the world as supply chains were disrupted and shipping faced new hurdles.
The country has since largely recovered, but still-increasing infection rates in other regions have put off a complete return to past supply-chain efficiency, Shah said. China isn't out of the woods yet either, as revived US-China tensions risk the implementation of new tariffs and another trade conflict.
"Global supply chains mean that the world economy will only be as strong as the weakest link," Shah wrote, adding global growth and markets "may be the ultimate losers."
Tech is king
Recovery role: Risky booster
Among the few sectors that largely weathered the coronavirus plunge, tech stocks have since driven major US indexes to their current levels as investors crowd into popular names including Facebook, Apple, Microsoft, and Google. The firms' strong performance will likely continue, Shah said, with the pandemic speeding up society's transition to remote work.
The tech-led rally comes with its risks, however. Investor concentration in tech mega-caps was elevated before the coronavirus outbreak, and inflows fueled by stay-at-home plays increase the risk of a highly uneven market. If a major tech name falters, it could have collateral effects on the entire market, Shah warned.
"Even tech giants aren't fully immune to the negative impact of COVID-19, and a disappointing earnings result from any one of them risks reversing recent US equity gains," she wrote.
In all, the strategist expects financial markets to have largely stabilized. The tech sector's protection against the broad downturn "should contain the downside risks" from supply chain disruption and revived US-China tensions. Prices may retrace some of their gains, but a dive below late-March lows is unlikely, she said.
"At least investors can take comfort in the fact that the worst of the pandemic is likely behind us, the market bottoming process is underway, and with markets typically leading the economy, we are—plausibly—clear of the market lows," Shah wrote.
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