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After the sharpest stock sell-off since March, what's next?
THE fast and furious rebound in US equities that began in late March hit a lamp post on Thursday as the S&P 500 sank 5.9 per cent, while the Nasdaq and Dow sold off by 5.3 per cent and 6.9 per cent, respectively.
It was the worst day for US equities since March 16 when the S&P 500 declined by 12 per cent.
None of the sectors in the S&P 500 were up on the day. The steepest declines were in sectors most correlated to the reopening of the economy, such as energy (-9.5 per cent), financials (-8.2 per cent), materials (-7.8 per cent), and industrials (-7.1 per cent).
The broad risk-off move rippled across the asset landscape: the US Treasury curve flattened as 30-year yields ended 12 basis points lower, US credit widened (most notably energy names) and the US dollar strengthened.
Given the torrid pace of the equity rally over the last two months, the market was stretching itself in over-bought territory and it was not surprising to see a consolidation as investors digested gains against rising concerns related to:
1) second waves of infections appearing in several US states, such as Texas, Florida and Arizona, after re-opening;
2) the equity rally running ahead of fundamentals after the Fed at its June Federal Open Market Committee (FOMC) meeting characterised the economic recovery as uncertain and long drawn-out; and
3) increased uncertainty related to the US presidential elections as Donald Trump's polling numbers continue to fall amid nationwide protests.
This single-day decline might well be part of a larger pullback in the weeks ahead - corrections in excess of 10 per cent are not infrequent and investors could take some time to re-calibrate valuations to evolving market risks.
But we broadly see this phase of consolidation as a chance to opportunistically and incrementally buy structural long-term winners as their valuations become more attractive, as well as cyclical and value stocks with resilient balance sheets that would benefit from the economic re-opening ahead.
This sell-off so far is characterised by a sharp reversal of the rotation in market leadership into cyclical and value stocks (such as those in the financials, industrials and energy sectors), but we see this tactical rotation re-asserting itself if the economic recovery does pan out over the medium to long term as anticipated.
In the near term, we do not see systemic selling to be a serious concern for equities as yet.
The market does not appear under-hedged at this point, and only if the correction deepens significantly further would we see large-scale systemic selling triggered at funds employing strategies such as CTA (commodity trading adviser) and risk parity.
One wild card for markets is the risk of second waves of infection, which will continue to evolve rapidly.
At this point, however, there are some grounds to be hopeful that the economic and market impacts of new waves of infection would be relatively contained versus the first peaks of the pandemic.
The public and policymakers now have greater knowledge and awareness of the Covid-19 virus.
There is a higher level of preparedness and, at the same time, lower political appetite to re-impose full shutdowns.
There is a tremendous race for effective antiviral drugs and vaccines among hundreds of candidates, and it is difficult to bet against the scenario of at least a few successes ahead.
Finally, policymakers have implemented unprecedented stimulus with a significant degree of success in supporting financial conditions - and they stand ready to do more if needed.
Therefore, at this point we see limited signs that the equity market would revisit the levels of the March bottom, which were then reflecting far greater levels of uncertainties.
That includes the real risk of a greater financial blow-up stemming from the tremendous liquidity pressures at that time, which has now mostly diminished.
As affirmed by the Fed's latest dovish message on the path of rates, disinflationary risks and the potential employment of forward guidance with yield caps at its June FOMC meeting earlier this week, ultra-low rates are here to stay for some time.
In a world with lower-for-longer rates, the search for yield is expected to be a powerful market driver, which underpins our constructive long-term view on emerging market high yield bonds.
As valuations become more attractive alongside a broad risk-off move, we will also look to add exposure to selective attractive opportunities in this asset class.
- The writer is head of investment strategy, Bank of Singapore