Pandemic fears escalate

The negative impact of the virus on global growth could persist and be more costly. On Friday, equities shed more than 1% and US Treasury yields reached an all-time low. Over the week, the decline in stock markets was modest but accelerated on Monday morning (24 February), with Seoul losing more than 3%. Gold reached a 7-year high.

The bond market anticipates rate cuts

The threat to global growth posed by the spread of the coronavirus outside China has benefited government bonds. Yields on 30-year US Treasury bonds have fallen to 1.89%, and 10-year yields fell to 1.47%. The futures market on short-term rates is pricing in nearly two 0.25% rate cuts by year-end.

This belief of falling rates in the future explains why investors are so keen on bonds when yields are staggeringly low.

PMI: a positive surprise in Europe but negative in the USA

Surprisingly, the Purchaser Managers' Index (PMI) in Europe was better than expected, while in the US it was the other way round.

The euro area manufacturing PMI index edged up to 49.1 in February, from 47.9 in January. There was a notable improvement in Germany. The index remains below the 50 level, which still points to slower growth in the industry but the trough appears to be behind us. With the Services PMI also nudging up, the composite index stands at 51.6 in total.

In the United States, on the other hand, the Manufacturing PMI fell from 51.9 to 50.8 and the Services PMI from 53.4 to 49.4.  This nasty surprise slightly pushed down the dollar, which had been particularly strong since early February.

What can we conclude at this stage?

Given the (possibly) excessive optimism that drove up US indices to new record highs last Wednesday, uncertainty fuelled by the spread of the coronavirus outside China and, potentially, the choice of the Democratic candidate for the US presidential elections, could bring back volatility. In other words, declines are expected.

Can the sharp rise in safe-haven assets (Treasury bonds, precious metals and even the dollar) remain compatible with the good stock market performance? Probably not if the health crisis worsens and lasts longer than expected. The economic cost will not be recovered in a few months.

But paradoxically, the more bond yields fall, the greater the risk premium offered by equities.  As the value of shares is the discounted value of future earnings, the latter is growing with the fall in long-term rates. The assumption is that earnings in the coming years are not likely to be affected by the coronavirus.

What strategy should be adopted?

The foreseeable spike in volatility prompts us to be cautious, but not negative. It makes sense to take some profits on overly popular stocks with a view to reinvesting at better prices and/or in sectors or themes that are less vulnerable from a valuation point of view. Buying on weakness remains a good strategy that has not been relevant before now, owing to the lack of significant downside.

The same applies to the euro against the dollar. At around 1.08, the dollar is overbought and overvalued (purchasing power parity at $1.28). The dollar is benefiting from its safe-haven status. That said, the fall in the US PMI to below 50 and the narrowing of the rate differential should reduce its strength. When China and the rest of Asia recover once the epidemic is contained, Europe and Japan should benefit more than the US. This scenario should benefit the eurozone and Japanese currencies.